Derivatives

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Does the level of capital formation track the level of derivatives outstanding? Were derivatives being written as hedges on "real assets"? Or were they being used as speculative products? Graph source: Adam S. Posen and Marc Hinterschweiger

See also Credit default swaps, CDS clearing, CDS confirmation, CFTC, and ***House derivatives 2009***, and Regulatory harmonization

Contents

Senate oversight

Reed's bill - "Comprehensive Derivatives Regulation for 2009"

Senator Reed's proposed legislation for derivatives regulation

To comprehensively regulate derivatives markets to increase transparency and reduce risks in the financial system.

IN THE SENATE OF THE UNITED STATES:

Mr. REED introduced the following bill; which was read twice and referred to the Committee on

  • A BILL:

To comprehensively regulate derivatives markets to increase transparency and reduce risks in the financial system.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE; TABLE OF CONTENTS. (a) SHORT TITLE.—This Act may be cited as the ‘‘Comprehensive Derivatives Regulation Act of 2009’’.

See the link for the proposed legislation.

Reed proposes SEC regulate CDS and security-based futures

"U.S. Senator Jack Reed proposed giving the Securities and Exchange Commission jurisdiction over futures based on securities, which are now overseen by the Commodity Futures Trading Commission.

The legislation introduced today by Reed, a Rhode Island Democrat who leads a Senate banking subcommittee that oversees the securities industry, also requires guaranteeing all standardized over-the-counter derivatives with central counterparties. The SEC and CFTC have been told by the Obama administration to work out which agency should oversee various assets classes like interest-rate and credit-default swaps.

The bill “amends the definition of ‘security future’ in the federal securities laws to provide the SEC with authority over all security futures, not just single-security and narrow- based security index futures,” according to a summary of Reed’s bill put out by his office today.

To accomplish the new SEC oversight, Reed proposes “a provision to transfer employees of the CFTC to the SEC, with protections in pay and benefits, if such employees would be more effectively utilized at the SEC.”

The CFTC has overseen futures contracts based on equity indexes like the Standard & Poor’s 500 Index and on Treasury debt since their inception decades ago. CME Group Inc., the world’s largest futures exchange, trades futures on the S&P 500 index as well as other equity indexes, Treasuries and interest rates and is regulated by the CFTC."

Cantwell's bills

"Current law makes it difficult for the Commodities Futures Trading Commission to effectively meet its mandate to investigate and punish market manipulation, resulting in little or no deterrent against abusive practices. This is because current law sets a very high bar for the CFTC to prove market manipulation. By comparison, a lower burden of proof makes it much easier for the Securities and Exchange Commission (SEC), the Federal Energy Regulatory Commission (FERC), and the Federal Trade Commission (FTC) to prove and deter market manipulation.

The CFTC must prove “specific intent” to do harm, rather than the “recklessness” standard used by the SEC for the past 75 years, and recently employed by the FERC and FTC. “Specific intent” is a much more difficult standard to prove. In fact, the standard is so weak that in its 35-year history, the CFTC has successfully prosecuted and won only one case of manipulation in the futures markets.

Cantwell’s bill would give the CFTC the same “reckless conduct” standard currently used by the SEC, the FERC, and the FTC against manipulation. It would establish a bright line so that the CFTC can effectively enforce and deter market manipulation in commodity futures and derivatives markets. Cantwell’s bill would make it clear that market manipulation resulting from “reckless conduct” will be illegal.

"In 2000, Congress passed a little-known provision in the Commodities Futures Modernization Act (CFMA) of 2000 that exempts derivatives traders from state gambling regulations. Cantwell’s proposal would repeal this provision. Since the CFMA went into effect, the derivatives market has ballooned from $80 trillion to more than $600 trillion. The lack of any regulations at the federal level meant that, in effect, the 2000 law made it open season for rampant derivatives speculation that culminated in the economic collapse of 2008.

The legislation Cantwell, Wyden and Sanders proposed today sends the message to derivatives dealers that if they somehow succeed in preserving regulatory loopholes at the federal level, they will still face tough regulatory oversight at the state level.

“Our ultimate goal is a strong, uniform set of federal regulations,” Cantwell continued, pointing to legislation proposed today by Senator Christopher Dodd (D-CT), chairman of the Senate Committee on Banking, Housing and Urban Affairs, that seeks to address loopholes and exemptions in federal derivatives law. “I am pleased that Senator Dodd today is moving forward with important legislation to regulate the dark derivatives market, and I look to the Senate Agriculture Committee to play a critical role as well. Congress must take a strong stand to prevent the kinds of abuses that have cost American workers and taxpayers so much. Empowering states restores an important layer of protection.”

While the Senate Banking Committee is proposing new rules on derivatives markets, the Senate Agriculture Committee has primary jurisdiction in amending the Commodity Exchange Act – the law that governs derivatives trading.

Senate Agriculture Committee hearing on Dec 2

Witnesses:

Panel 1: Commodity Futures Trading Commission

Panel 2: Stakeholders

  • Mr. Terrence Duffy, Executive Chairman, CME Group, Chicago, IL
  • Mr. Johnathan Short, Senior Vice President, General Counsel and Corporate Secretary, Intercontinental Exchange (ICE), Atlanta, GA
  • Mr. Larry Thompson, Managing Director and General Counsel, The Depository Trust & Clearing Organization (DTCC), New York, NY
  • Mr. Peter Axilrod, Managing Director, The Depository Trust & Clearing Organization (DTCC), New York, NY
  • Ms. Blythe Masters, Managing Director and Head of Global Commodities Group, JPMorgan Chase & Co., New York, NY
  • Mr. Jiro Okochi, CEO, Reval.com, Inc., New York, NY

Joint Economic Committee hearing Dec 2

The Joint Economic Committee held a hearing entitled “Unregulated Markets: How Regulatory Reform Will Shine A Light in the Financial Sector.” The hearing examined how the financial sectors referred to as the “dark market,” the unregulated over-the-counter market, and lightly regulated mortgage markets contributed to the financial crisis.

Testifying before the Committee were the following individuals:

  • Brooksley Born, former Chair of the Commodity Futures Trading Commission
  • Robert Litan, Senior Fellow in Economic Studies, Brookings Institution, Vice President of Research and Policy at the Ewing Marion Kauffman Foundation, and member of the Task Force on Financial Reform
  • James Carr, Chief Operating Officer, National Community Reinvestment Coalition
  • Robert K. Steel, former Under Secretary for Domestic Finance, United States Treasury, chairman of the board of The Aspen Institute and a member of the Task Force on Financial Reform

In her opening remarks Committee Chairwoman Carolyn Maloney (D-NY) asserted that the financial crisis was triggered in part by the highly unregulated over-the-counter (OTC) derivatives and credit default swap (CDS) markets that, in the absence of regulation, created an “illusion that the assets [underlying such products] were risk-free.” She also noted that “[a]t its peak, this unregulated market was tied to $680 trillion in assets,” an amount equal to 50 times the U.S. GDP, placing the financial stability of the United States and the global economy at risk, and emphasized the need to adopt “common-sense regulation of the financial services industry to insure stability and safety of the system.”

Ms. Born stated that certain regulatory gaps, including a failure to regulate OTC derivatives, played a significant role in the financial crisis. She stated that, from the perspective of a former regulator, the lack of transparency and price discovery, excessive leverage, undue speculation, inadequate capital and prudential controls made the market “extremely dangerous.” Ms. Born stressed that the CFTC and the SEC should be granted primary “regulatory responsibilities” for the trading of derivatives both on and off exchanges. In addition, she noted that, with respect to futures and options, “all standardized and standardizable derivatives contract[s] should be traded on regulated derivatives exchanges and cleared through regulated derivatives clearing operations” with no exceptions.

Senate Agriculture Committee hearing on Nov 18

Witnesses:

  • The Honorable Gary Gensler, Chairman, Commodity Futures Trading Commission
  • The Honorable Glenn English, Chief Executive Officer, National Rural Electric Cooperatives
  • Mr. Neil Schloss, Treasurer, Ford Motor Company
  • Mr. Mark Boling, Executive Vice President & General Counsel, Southwestern Energy Company
  • Mr. Jeff Billings, Manager of Risk Management, Municipal Gas Authority of Georgia on behalf of the American Public Gas Association Kennesaw, GA
  • Mr. Robert A. Johnson, Director of Economic Policy, The Roosevelt Institute, on behalf of the Americans for Financial Reform


"As Congress crafts legislation to impose new oversight on complex instruments blamed for hastening the financial crisis, a major sticking point has emerged over companies that use the derivatives to hedge risk.

Some lawmakers want to exempt so-called "end users" of derivatives from new capital and other requirements in the overhaul legislation. A potent coalition of about 170 companies that use derivatives -- including Boeing Co., Caterpillar Inc., Ford Motor Co., General Electric Co. and Shell Oil Co. -- has been lobbying Congress to say that regulation of derivatives without exceptions could severely increase costs for corporate America.

That could mean higher costs passed on to consumers and imperiled jobs, they contend.

"We are concerned that imposing clearing, margin and capital requirements on end users would significantly increase our cash requirements and costs," Ford Vice President and Treasurer Neil Schloss testified.

Echoes of support came from several members of the Senate Agriculture Committee at a hearing Wednesday.

"This has some very, very serious consequences" for farmers and other businesses, said Sen. Mike Johanns, R-Neb.

Sen. Debbie Stabenow, D-Mich., said it would be a hardship for manufacturing companies to have to divert sorely needed working capital to put up as collateral under the new requirements.

But Gary Gensler, chairman of the Commodity Futures Trading Commission, told the panel that if Congress decides to exempt some end-user transactions, the exception should be "explicit and narrow."

Broader exemptions could allow financial market players such as hedge funds, for example, to benefit from them, Gensler says.

The value of derivatives hinges on an underlying investment or commodity -- such as currency rates, oil futures or interest rates. The derivative is designed to reduce the risk of loss from the underlying asset.

Companies of all kinds use derivatives to hedge against risks -- airlines ensuring against spikes in fuel prices, for example. At the same time, derivatives have become a growing vehicle for financial speculation and ballooned into a sprawling $600 trillion market. Regulators say they pose a threat to the stability of the financial system.

Credit default swaps, a form of insurance against loan defaults, account for an estimated $60 trillion of the derivatives market. The collapse of the swaps brought the downfall of Wall Street banking house Lehman Brothers Holdings Inc. and nearly toppled American International Group Inc. last year.

The subsequent $180 billion taxpayer bailout of the insurance conglomerate damaged manufacturers and the economy. Tough new oversight of an unregulated global derivatives market is needed to prevent another crisis, Gensler said.

Sen. Blanche Lincoln, D-Ark., the Agriculture Committee chairman, may draft a bill to regulate derivatives. At the same time, Senate Banking Committee Chairman Christopher Dodd, D-Conn., has proposed a derivatives measure with exemptions for end users that are narrower than those in the House legislation."

Senate Banking Committee hearing on June 22

In a Senate Banking Committee hearing on June 22, 2009 lawmakers raised issues which will help shape legislation for the oversight of derivatives. The main issues discussed at the hearing include:

  • How will derivatives regulation fit with the establishment of a systemic regulator and international regulation and oversight?
  • The definition of "'standardized' versus 'custom' derivatives". No clear understanding emerged.
  • Are derivatives a form of insurance or speculation? Derivatives are used for both.
  • Regulating derivatives in the context of linked "cash" securities market (eg corporate bonds and CDS)
  • Likely that interest rates, foreign exchange, commodities, energy, and metals derivatives will be overseen by the CFTC.
  • Likely responsibility for "securities-related" OTC derivatives would be retained by the SEC,
  • If OTC derivative oversight is bifurcated how will dealers be regulated?(eg as overseen by the CFTC and/or the SEC)? Typically dealers trade all types of derivatives.
  • CFTC Chairman Gensler discussed regulating "big market functions" for example central clearing facilities and "regulated trading venues".
  • Federal Reserve belives that there should be priority on the development of a "trade information warehouse" for all asset classes.
  • All regulators must share information about oversight (XBRL?).
  • Chairman Gensler suggested that the public should have access to realtime data like TRACE for products trading on exchanges and alternative trading systems (ECNs).
  • The use of margin and collateral will enhance system stability.
  • Chairman Gensler suggested that approximiately half of the OTC deriv markets are standardized. He said that generally if you can't standardize a product it is harder to unwind in times of crisis and therefore has more risk.
  • Will bank regulators oversee the derivatives trading activities of the broker/dealers subsidiaries of commercial banks (Citi, JPM, Goldman Sachs, Morgan Stanley)?
  • The Federal Reserve supports giving access to borrowing to a CCP in a a crisis.
  • Two views of derivatives... 1) 'weapons of mass destruction' 2) useful products that serve to rationalize markets by balancing risk between many entities.
  • Derivatives are systemically unstable if not referenced to an underlying cash market.
  • In a CCP should customer cash be segregated?
  • "Empty creditor" phenomenon where CDS holder has incentive to aggressively demand collateral and whose interests are often not aligned with the name on which they hold CDS.
  • There is no market for CDS for midsize companies only large names.
  • Price transparency will reduce the profits of the handful of dealers who currently control these markets.
  • Smaller market participants will mostly benefit from increased transparency.


Members, who exempted private derivatives from oversight in 2000, are targeting the financial instruments after American International Group Inc. needed a $182.5 billion U.S. bailout because of credit-default swap trades on mortgage-linked securities.

“One of the key underlying problems in the whole lead-up to the meltdown was too much leverage, too little capital or too little collateral,” Mark Halverson, a staff director for Senate Agriculture Committee Chairman Tom Harkin, said in an interview.

Harkin, an Iowa Democrat, is pushing his own legislation that would require all over-the-counter derivatives trades be cleared through a regulated exchange. Such an arrangement would subject the contracts to margin and collateral requirements. Harkin, who endorsed Obama’s proposal to move some trades to an exchange and regulate all dealers, still plans to press forward.

(Source: Bloomberg June 22, 2009)

The Senate Agriculture Committee introduced S. 272 deferred

  • -- Requires exchange trading of all OTC derivatives

House oversight

See also House derivatives 2009.

Senior lawmakers near swaps crackdown consensus

Senior Democratic lawmakers have agreed on all but a few details of a plan for over-the-counter derivatives regulation, suggesting consensus is near on one of the trickiest parts of the Obama administration's effort to tighten U.S. financial oversight.

Draft legislative language obtained by Reuters on Sunday shows the chairmen of two House of Representatives' financial committees want OTC derivatives to be centrally cleared and traded on exchanges or other platforms where possible.

The draft language -- reflecting a compromise between House Financial Services Committee Chairman Barney Frank and House Agriculture Committee Chairman Collin Peterson -- resembles a bill unveiled last month by Senator Christopher Dodd.

Dodd chairs the Senate Banking Committee, which is handling financial reform efforts. Peterson and Frank have worked for weeks on their 227-page amendment, to be offered this week on the House floor as part of a sweeping reform bill.

The House is expected to pass the broader bill, with the OTC derivatives language, possibly as soon as Friday.

That would throw the reform effort, now more than a year old, fully onto the shoulders of the Senate, which is expected to debate the many issues surrounding it well into 2010.

Both clearing and exchange trading are meant to hold more accountable a $450 trillion market, now unregulated, which is widely blamed for aggravating last year's financial crisis.

Financial services industry interests fear new regulations will increase their costs, cut their profits and frustrate companies' ability to manage risk. The U.S. Chamber of Commerce, for instance, wrote to lawmakers on Friday saying legislation could hamper major pension funds' operations.

OTC derivatives are financial contracts that now trade off-exchange among the biggest financial institutions and so-called end users, such as airlines and agribusinesses.

Goldman Sachs, JPMorgan Chase, Citigroup, Bank of America and Morgan Stanley dominate the derivatives market and reap huge gains from it.

The market includes credit default swaps. Former insurance giant AIG got into deep trouble after it sold hundreds of billions of dollars worth of these swaps, triggering a massive taxpayer bailout under the Bush administration.

BALANCING ACT

Much OTC derivatives trading involves financial firms placing bets on changes in debt defaults, interest rates and commodity or stock prices, but businesses also use it to hedge against risks affecting costs for fuel and other commodities.

Lawmakers have been trying for months to balance a desire to curb speculative excess while preserving the market's useful role in helping corporations hedge against operational risks.

Two issues that Frank and Peterson could not agree on remain to be decided on the House floor -- whether to limit ownership in swaps clearinghouses, and whether regulators would have the power to set margin and capital requirements on swaps traded by nonfinancial end users, House aides said.

Clearinghouses stand between parties to a trade and assume the risk if one of the parties fails. These middlemen usually require both counterparties to front collateral, a cost that end users of swaps say they would be hard-pressed to meet.

Frank and Peterson want swaps to be centrally cleared when a clearinghouse will accept them, and when regulators determine clearing is necessary.

Swaps not accepted for clearing would have to be reported to a swap repository or regulators.

In an important exemption for end users, clearing could be waived when one counterparty "is not a swap dealer or major swap participant" or is "using swaps to hedge or mitigate commercial risk." Frank, Peterson and Dodd agree on this.

Swaps that are cleared must be traded on an exchange or a registered execution facility, Frank and Peterson proposed.

If that's not possible, counterparties must meet recordkeeping and reporting requirements. Regulators would write rules to prevent abuse of the exemption for end users and set position limits, as well, "to diminish, eliminate, or prevent excessive speculation."

Frank and Peterson want to prohibit government support for a troubled clearinghouse, as well, except "where explicitly authorized by an act of Congress."

The administration is under international pressure on the issue. The G20 group of countries has agreed that OTC derivatives should trade on an exchange or platform, where appropriate, and clear centrally by the end of 2012.


Regulators to decide whether products centrally clear


U.S. regulators should be given authority to determine whether a privately traded derivative contract should be cleared through a central clearinghouse, the chairman of the House Financial Services Committee said on Tuesday.

The move would be highly controversial as clearinghouses, which stand between parties to the trade and assume the risk of the failure of one of the parties, have maintained they should have the right to determine what contracts they clear and they have expressed reluctance about clearing risky contracts.

The congressional panel has approved a bill to regulate the $450 trillion over-the-counter derivatives market, after credit default swaps (CDS) were blamed for exacerbating the global financial crisis.

But Financial Services Committee Chairman Barney Frank said he wanted to change the bill to take authority to determine whether swaps are clearable away from private clearinghouses.

“I am having staff prepare an amendment to give that function back” to the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), Frank told reporters.

Under Frank’s bill, private clearinghouses, some of which are owned by financial institutions, have the power to determine whether a swap can be cleared.

But in a potential loophole, financial firms, which oppose the mandate that certain derivatives be traded, might have an incentive to not declare trades clearable, Frank told reporters.

The change will likely face opposition from market participants who have said that clearinghouses should have the option to decline risky or hard to value assets if they are put at risk of failing themselves.

“If central counterparties are forced to clear something they don’t feel comfortable with, we’d end up creating new systemic risk rather than reducing it,” said Kevin McPartland, senior analyst at TABB Group in New York.

Frank also said trading between financial institutions will need to be made on exchanges, without exemption. This rule would cover all banks that have traded with American International Group <AIG.N>, which he deemed “the poster child” of derivative problems.

AIG needed a government bailout out after selling hundreds of billions of dollars of protection on risky assets using CDSs.

Frank said he and House Agriculture Committee chairman Collin Peterson are very close to a deal to merge both panel’s bills.

SYSTEMIC RISKS Clearinghouses concentrate the exposures of large trading counterparties, and pose large risks to the financial system if they are undercapitalized.

Derivative contracts can be used to hedge against or bet on the changes in value of the underlying assets such as stocks, bonds, commodities.

Enforcing margin requirements on many derivatives, such as credit default swaps, can be challenging as the value of the contracts can rapidly change if a borrower is suddenly deemed near default. In some cases defaults can occur before sufficient collateral payments can be made.

“There’s a fairly significant risk that if a regulator decides they have to clear something and can set capital or otherwise determine how to appropriately clear a product, we have succeeded in just pushing risk to clearing corporations and raised the risk that they may not have adequate capital,” said Paul Forrester, partner at law firm Mayer Brown in Chicago.

“That’s a potentially larger problem than the one we’re trying to solve,” he said.

Executives at CME Group Inc and LCH.Clearnet, both of which plan to clear credit default swaps, have said they are wary of clearing contracts that trade infrequently or have few pricing sources. For details, see

Frank said he also requested the change in a letter to CFTC Chairman Gary Gensler. The full House still needs to vote on the bill, and the Senate must agree before president Barack Obama could sign it into law.

House Agriculture Committee passes bill

"The House Agriculture Committee approved legislation regulating over-the-counter derivatives after adopting a provision that may speed agreement on regulation of the $592 trillion industry.

The amendment by committee Chairman Collin Peterson would exempt end-users -- companies such as manufacturers and airlines that employ derivatives to hedge their operational risks -- from increased capital, trading and disclosure requirements.

“In crafting this bill, our target for greater regulation and oversight is not the end-user but their swap dealer or major swap participant counterparty,” Peterson, a Minnesota Democrat, said during debate on the bill. “End-users did not get a bailout of billions of dollars. End-users are not responsible for what happened in markets last year.”

The legislation was approved by voice vote. The House Financial Services Committee approved a bill on Oct. 15 with a similar exemption for end-users.

The Obama administration called in August for Congress to enact rules governing the over-the-counter derivatives market, saying a lack of transparency exacerbated the credit crisis and contributed to the near-failure of American International Group Inc.

Opaque financial products including derivatives have contributed to almost $1.6 trillion in writedowns and losses at the world’s biggest banks, brokers and insurers since the start of 2007, according to data compiled by Bloomberg.

Gensler’s Comment

Gary Gensler, chairman of the Commodity Futures Trading Commission, said in a speech in Chicago today that any exemption for end-users “should be very narrowly defined” to include only nonfinancial institutions.

Peterson said the legislation approved today wouldn’t open broad loopholes.

“Seventy to 80 percent of this stuff will be cleared,” Peterson told reporters after the committee met. “The clearinghouse will decide what gets cleared, not some government agency.”

Both bills in the House would set new margin and trading requirements for swaps dealers and “major swap participants.” Sponsors of the measure say that would apply the rules to the biggest users of derivatives, including hedge funds, AIG and mortgage-finance companies Fannie Mae and Freddie Mac.

“Our initial review is positive,” said David Schryver, executive vice president of the American Public Gas Association, a trade group representing small U.S. gas utilities. Without the exemption, he said his group’s members, which use derivatives to manage price and supply risks, would have to raise prices or limit use of the instruments.

Position Limits

The Agriculture Committee also adopted by voice vote a provision that would restrict the CFTC Commission’s power to set position limits for derivatives dealers.

The amendment would require the CFTC to develop position limits for “all economically equivalent contracts on all trading venues concurrently” and to impose those limits “with the intention to mitigate” the loss of trading on U.S. exchanges.

Giving regulators broad authority to set position limits, as the Agriculture Committee originally proposed, would result in a “flight of trading -- from the very type of transparent, responsible regulation the bill is trying to encourage to less transparent trading platforms,” said Representative Debbie Halvorson. The Illinois Democrat co-sponsored the provision with Representative Robert Goodlatte, a Virginia Republican.

‘Excessive’ Speculation

Gensler has said the CFTC has authority to limit “excessive” speculative trading in energy markets. He has asked Congress for the authority to also restrict commodity speculation in the over-the-counter derivatives market, where regulatory gaps allow traders to amass positions far larger than limits intended to keep one trader from gaining too much control.

Speculators include index- and exchange-traded funds and other traders that don’t take physical delivery of a commodity.

CME Group Inc., the world’s largest futures market, told U.S. lawmakers and regulators that business is already moving abroad because of potential trading limits under consideration by the commission.

Companies that offer derivatives investments, including Deutsche Bank AG, have shifted activity to markets outside the U.S. because of the proposed limits, Chicago-based CME said in a letter to Gensler dated yesterday.

House Financial Services Committee passes bill

"The House Financial Services Committee today approved legislation that would, for the first time ever, require the comprehensive regulation of the over-the-counter (OTC) derivatives marketplace. Today’s bill, which was approved by a vote of 43-26, represents a key part of a broader effort by Congress and President Obama to modernize America’s financial regulatory system in response to last year’s financial crisis.

Under the bill, all standardized swap transactions between dealers and large market participants, referred to as “major swap participants,” would have to be cleared and must be traded on an exchange or electronic platform. A major swap participant is defined as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions creates such significant exposure to others that it requires monitoring. OTC derivatives include swaps, which are contracts that call for an exchange of cash between two counterparties based on an underlying rate, index, credit event or the performance of an asset.

The legislation then sets out parallel regulatory frameworks for the regulation of swap markets, dealers, and major swap participants. Rulemaking authority is held jointly by the Commodity Futures Trading Commission (CFTC), which has jurisdiction over swaps, and the Securities and Exchange Commission (SEC), which has jurisdiction over security-based swaps. The Treasury Department is given the authority to issue final rules if the CFTC and SEC cannot decide on a joint approach within 180 days. Subsequent interpretations of rules must be agreed to jointly by the Commissions.

Description of the Over-the-Counter Derivatives Markets Act of 2009


House Committee on Agriculture draft of proposed legislation


House Fin Service Committee draft of proposed legislation


Concept paper for OTC derivatives legislation

Source: Chairmen Peterson and Frank's "Description of Principles for OTC Derivatives Legislation" July 30, 2009

Chairman Peterson said: “I am pleased that Chairman Frank and I were able to come to agreement on so many principles with regard to OTC derivatives reform. I think we have come up with a responsible approach that bridges the differences between those members who want to completely eliminate the over-the-counter market and those who think that just greater transparency is all that is needed. Neither of those approaches is a real solution; what we are putting forth is.

“Putting this concept paper out now will give members of both Committees plenty of time to review it, develop ideas, suggestions, thoughts and comments so everyone will be prepared to tackle these issues when we return in September. I look forward to working with Chairman Frank so we can enact legislation that gives the American people the confidence that our markets are being overseen and monitored by strong, effective regulators.”

Chairman Frank said: “The fundamental purpose here is to improve the regulation of derivatives so that they continue to perform their important market function but are less likely to contribute to a kind of irresponsibility that can cause a crisis. Nobody here wants to ban them or even severely diminish them as an economic instrument. The Committee on Agriculture represents a lot of end users for whom they are very important. The Committee on Financial Services deals with a lot of the financial institutions. They have an interest that has to be blended. I thank Chairman Peterson and his staff for their cooperation on this effort.”

Robust Oversight of Dealers and Markets

Depending on the underlying asset on which a derivative is based, either the SEC or the CFTC, or potentially both, will oversee the regulation of OTC derivative dealers, exchanges and clearinghouses.

    • Clearinghouse Regulation: Clearinghouses will be robustly regulated. Primary oversight authority of the CDS clearinghouse, ICE Trust, will be shifted from the Federal Reserve to a market regulator after a period not longer than six months from the date of enactment.
    • Trade Reporting: All OTC derivative trades must be reported to a qualified trade repository.
    • Regulatory Approval: Requests for approval as a clearinghouse, exchange or electronic trading platform must be acted on by the relative agency within 180 days.
    • Regulatory Harmonization: The statutory and regulatory powers of the SEC and CFTC shall be harmonized with respect to the OTC derivative market including registration requirements for dealers.

Mandatory Clearing of OTC Derivatives

Derivatives must be cleared by an approved clearinghouse. Exchange trading and trading on electronic trading platforms will be strongly incentivized and encouraged.

Exceptions:

    • Appropriate regulator determines the product is not sufficiently standardized to be cleared or no qualified clearing mechanism exists.
    • One party in the transaction does not qualify as a “major market participant” as determined by the appropriate regulator in consultation with the Financial Services Oversight Council.

Regulators should have:

    • Authority to prohibit or regulate transactions that are not traded on exchange or cleared.

Strengthening Capital and Margin Requirements

  • Appropriate regulators will develop margin and capital requirements that create a strong incentive for dealers and users of derivatives to trade them on an exchange or electronic trading platform or have them cleared whenever possible.
  • Significantly higher capital and margin charges will apply to non-standardized transactions that are not exchange-traded or centrally cleared.
  • Regulators can authorize use of non-cash collateral to satisfy margin requirements.

Particular Attention to Speculation

At least two options will be considered:

1. Limitation on Speculation

Prohibition on any purchase of credit protection using a CDS contracts unless:

    • The party owns the referenced security or (one or more) of the securities in an index of securities.
    • The party has a bona fide economic interest that will be protected by the contract.
    • The party is a bona fide market maker.
    • Regulators will have authority to monitor market activity and impose position limit where necessary.

2. Enhanced Oversight of Speculative Positions

Require confidential reporting to the appropriate regulator of all short interest in CDS contracts by:

  • OTC derivatives dealers;
  • Investment advisers that manages in excess of $100 million;
  • Other entities that are deemed “major market participants”.

In order to prevent abuse, the appropriate regulator has authority to:

  • Impose position limits on market participants;
  • Ban the purchase of credit protection using CDS by any non-dealer that is not hedging a risk.

Protect U.S. Financial Institutions from Lesser Regulatory Standards in Other Countries

  • U.S. regulators will coordinate with foreign regulators on harmonizing OTC derivative market regulation including recognized international standards with respect to clearinghouses.
  • The Treasury Department will be authorized to restrict access to the U.S. banking system for institutions of any jurisdiction Treasury finds permits capital-related standards that are lower than the United States or that promote reckless market activity.

Role of Financial Services Oversight Council

  • Resolve disputes between the SEC and CFTC over authority over new products within 180 days.
  • Resolve disputes between the SEC and CFTC over joint regulation of derivative products within 180 days.

Enforcement

  • Agencies shall have enforcement authority over products under their jurisdiction.
  • Agencies shall hold enforcement authority jointly for any products subject to joint jurisdiction.

House Financial Services Committee hearing October 7

Watch archived video of hearing here.

Witnesses:

  • The Honorable Gary Gensler, Chairman, Commodity Futures Trading Commission
  • Mr. Henry Hu, Director, Division of Risk, Strategy, and Financial Innovation, U.S. Securities and Exchange Commission

For additional witness statements go here.

House Agriculture Committee hearing September 22

RE: To review proposed legislation by the U.S. Department of Treasury regarding the regulation of over-the-counter derivatives markets, part one.


Media coverage

House Agriculture Committee hearing September 17

House Agriculture Committee hearing September 17, 2009

10:30 a.m. 1300 Longworth House Office Building, Full Committee – Public Hearing

RE: To review proposed legislation by the U.S. Department of Treasury regarding the regulation of over-the-counter derivatives markets, part one.


  • Mr. Daniel N. Budofsky, Davis Polk & Wardwell LLP, on behalf of the Securities Industry and Financial Markets Association, New York, New York

"Congress should only require mandatory clearing of standardized interdealer over-the-counter derivatives transactions in which at least one of the dealers is systemically significant, the chief executive officer of the International Swaps and Derivatives Association told lawmakers yesterday.

Both the Treasury Department’s proposed legislation and a bill sponsored by the chairmen of the House Financial Services and Agriculture committees would mandate central clearing and exchange trading of standardized derivatives contracts.

But Robert Pickel, the ISDA’s CEO, told members of the House Agriculture Committee yesterday, “Not all standardized contracts can be cleared.”


Joint hearing Agriculture Financial Services hearing July 10

Joint Committee hearing of the House Agriculture and House Financial Services Committee announced for Friday, July 10th at 10:00am. Treasury Secretary Geithner to testify (testimony link).

"Frank, in an interview with MSNBC (running time 5:35) after the hearing, said he would further limit the ability of businesses to enter into individualized derivative contracts.

"We will specifically be requiring that in almost every case derivatives go on an exchange ... or a clearinghouse, that there not be these individualized deals," he said. "And if people are going to make individualized deals, they're going to have to have a lot more capital behind it. "

Frank also said he would call for a ban on so-called naked credit default swaps, a type of derivative where buyers have no risk of exposure.

Some Democrats have called for fewer customized derivatives contracts and a few have urged that some derivatives, such as credit default swaps, be banned."

"A major battle is brewing, however, over definitions. At root it boils down to how regulators and the market determine the difference between a standardized derivative and a customized derivative.

In his testimony before a joint hearing of the House Financial Services Committee and House Agriculture Committee, Geithner said that the administration would use a “broad definition” of standardized derivatives that would be “difficult to evade.” The administration proposal would raise capital requirements for customized derivatives, “given their higher levels of risk.”

Geithner said that the administration would likely recommend broad principles in statute and then define them further in regulation.

Banks and a range of other non-financial firms are lobbying heavily on derivatives legislation, which is one part of the administration’s plan to revamp regulations for the wider financial system.

Four major Washington lobbying associations -- Business Roundtable, U.S. Chamber of Commerce, National Association of Manufacturers and The Association of Food, Beverage and Consumer Products Companies -- wrote in a letter on Friday that the proposal would increase the cost of business. “We urge you to prevent an anti-derivatives sentiment from translating into anti-business legislation,” the associations wrote.

A separate letter from 15 associations representing the electric power and natural gas industries raised concern with the mandatory clearing provision and the effort to move OTC derivatives onto public exchanges. The proposals, the associations said, would “significantly increase costs,” and “greatly reduce the ability of companies to find the customized derivative products they need to manage their risks.”

HR 977 --Agriculture Committee

The House Agriculture Committee approved H.R. 977 - which has been deferred indefinitely

  • -- Require most non-exchange (OTC) derivatives to be settled through a registered CCP
  • -- Gives the CFTC some authority to suspend trading in CDS

HR 2454 Energy Committee

The House Energy Committee approved H.R. 2454 (deferred to other Committees)

-- Includes prohibition of "naked" CDS sales

US executive branch oversight and lawmaking

New OTC swaps rules must apply to all – U.S. regulatory official

Congress should not create blanket exemptions for end users from new rules designed to make trading of the over-the-counter derivatives more transparent, a commissioner on the top U.S. futures regulator said on Tuesday.

Michael Dunn said the Commodity Futures Trading Commission should be given the authority to exempt end users from requirements to trade and clear standardized derivatives on a case-by-case basis, but recommended against a broader exemption currently being considered by Senate committees.

“Allowing such a large class of transactions to be exempt from clearing would mean that dealers would have more risk on their books. If these dealers fail, this risk could affect the entire financial system,” Dunn said in remarks prepared for a National Futures Association regulatory seminar in Chicago.

Dunn’s comments are in line with CFTC Chairman Gary Gensler who has also argued against end user exemptions.

Senate banking and agriculture committees are currently working on bills that would give regulators oversight of the OTC derivatives market that the CFTC estimates is worth about $300 trillion in the United States alone.

The House of Representatives’ bill, passed in December, included clearing exemptions for end users. Senate committees working on legislation have also signaled they plan to include some exemptions, but details have not yet been released.

Fannie and Freddie to centrally clear interest rate swaps

This is a big one: Fannie Mae and Freddie Mac will start using central counterparty clearing on their massive interest rate swaps portfolio, according to a Reuters report.

Why is it big? For one thing, the combined size of Fannie and Freddie’s interest rate portfolio is $3,000bn – or more than 20 per cent of the gross market value of the global interest rate swap market, according to BIS data as at June 2009.

Moreover, since Fannie and Freddie’s de facto nationalisation in 2008, they’ve gone from being ‘government sponsored’ entities to ‘the government’. As a result, as Reuters pointed out, their move to clearing “gave notice the government is putting its money where its mouth is”:

“You can’t kick and scream anymore because I am buy-side,” Martha Tirinnanzi, chairman of the Federal Housing Finance Agency’s clearinghouse working group, told reporters after a panel at the Futures Industry Association’s annual meeting here. “It will be a signal to the sell-side that this market has changed.”

As for just which of the competing clearing houses will have first dibs on that portfolio? Not yet, erm, clear:

The agencies have tested their portfolios with Nasdaq OMX Group Inc’s majority-owned clearinghouse, CME Group and LCH.Clearnet, she said, but they have not yet decided which to use

U.S. Treasury nominee: some swaps may stay off exchanges

"The nominee for the U.S. Treasury’s top domestic post on Tuesday said he believed certain derivatives contracts, such as dollar swaps, could be exempted from being traded on exchanges under Obama administration proposals to boost market transparency.

Jeffrey Goldstein, who was named in July 2009 to become Treasury undersecretary for domestic finance, told the Senate Finance Committee that the administration’s market reform proposals would prevent abuse and promote transparency, but there were certain cases where derivatives might be better off not traded on exchanges.

“I think that the exemptions would be in certain markets where you could adversely affect the trading of some important securities — including the dollar swaps, and other things,” Goldstein said, answering a question during a confirmation hearing. He added that he looked forward to examining the issue further with lawmakers.

Goldstein was asked about his views on currency swaps by Senator Maria Cantwell, a Democrat from Washington state, who criticized the use of cross-currency swaps employed by Goldman Sachs & Co on behalf of Greece as disguising the amount of Greece’s public debt.

“It’s all perfectly legal, but in my opinion its a scam, and we ought to have these regulated and on exchanges and have transparency and go through clearing houses,” Cantwell said.

Goldstein said he believed that the Treasury’s proposed improvements in trading practices for over-the-counter derivatives trade “is meant to restore confidence in the financial system and make sure that the we do not put taxpayers at risk in the way that occurred at the height of the financial crisis.”

Senators also questioned Goldstein about the work one of his previous employers — private equity firm Hellman & Friedman — did to set up tax-shelter “blocker” corporations in the Cayman Islands on be half of clients.

Goldstein said these entities were set up to aid tax-exempt organizations such as pension funds and universities to maintain their income as tax exempt.

NY Fed meets with dealers and buyside - January 14, 2010

Jan 14 (Reuters) - Big players in the $450 trillion derivatives markets agreed to increase transparency and expand the volume and type of contracts they route to central counterparties, the New York Federal Reserve said on Thursday.

Derivatives, which are based on underlying assets including bonds and commodities or can be tied to currency and interest rate moves, were blamed for exacerbating the credit crisis and contributed to a run on assets that helped fell banks including Lehman Brothers.

The latest effort is a bid by the industry to reduce risks in the privately traded markets. The industry has been under heavy pressure to become safer after the government bailed out American International Group (AIG.N) because the insurer had a massive exposure to risky assets using credit default swaps, which are used to insure against a debt default.

Large market participants -- including banks like JPMorgan Chase & Co (JPM.N), investment companies such as Pacific Investment Management Co and industry groups -- met with regulators on Thursday at a meeting hosted by the New York Fed.

They agreed to provide regulators with additional information on trades in an effort to enhance efforts to move more of the market to central counterparties.

"The industry must undertake a major transformation to bring significantly greater levels of transparency to these markets. Increasing the amount and quality of market information available to participants, regulators and the public is critical to the work of shoring up the stability and efficiency of the financial system," William Dudley, president of the New York Fed, said in the release.

Greater use of central counterparties, which stand between trading partners and guarantee trades, is expected to help reduce the risks of a bank run, which would improve the stability of the financial sector.

Banks and fund managers also agreed to expand the volume and range of contracts that are currently deemed eligible for central clearing.

Debate over what contracts are eligible for central clearing, however, remains lively as banks and clearinghouses fear that taking on the risks of hard-to-value contracts will only succeed in shifting risks from banks to the central counterparties.

Details over what trading information will be provided to regulators, and how much may be made available to the public, also remain unresolved, said a person with knowledge of Thursday's meeting.

Large derivatives participants will detail new commitments in a letter due to be sent to regulators by March 1.

Derivatives dealers and users also reaffirmed commitments to formalize best practices, including margining requirements, for derivatives that are not centrally cleared.

IntercontinentalExchange Inc (ICE.N) and CME Group (CME.O) are the only clearinghouses in the U.S. that have begun clearing CDSs.

Banks in September agreed to submit 95 percent of eligible credit derivatives, and 90 percent of eligible interest rate derivatives, to central counterparties.


Chairman Gensler's comments on regulating OTC derivatives January, 2010

"... Financial intermediation – that is, the pricing and allocation of capital and risk – is critical to every part of our economy. This intermediation can either be done through financial institutions – typically banks – or through the benefit of a centralized marketplace. The more standard the products are, the more able they are to trade in a marketplace. For example, investors buy and sell stocks in a marketplace.

Over-the-counter derivative contracts have become much more standardized. In fact, by some estimates, between two thirds and three quarters of interest rate derivatives and credit default swaps could be standardized. In energy and other commodity markets, some estimates are that approximately half could be standardized. With the standardization and computerization of derivative transactions, the time has come to bring the benefits of a central marketplace that lowers risk and allows market participants to see how contracts are priced.

Some opponents of reform argue that derivatives were not at the center of the crisis and should thus not be regulated. I believe, however, that over-the-counter derivatives were at the heart of the crisis. We have all witnessed firsthand the effects that unregulated derivatives had across the entire economy. Everybody in this room put money into a single company that was so interconnected with other financial institutions that its failure threatened the entire system. $180 billion of taxpayer money went into AIG. That’s about $600 from each person in this room.

But the lessons from the crisis go far beyond AIG. While derivatives are intended to help transfer and lower risk in the economy, the financial crisis demonstrated that they also can concentrate risk among a few big banks. All of the major derivatives dealers – all recipients of taxpayer TARP money – internalize their derivatives trading, retaining significant risk. Those banks have become increasingly interconnected with other institutions. The market also has become highly concentrated, with five or six big institutions on Wall Street and maybe 15 around the globe dealing in derivative products. Risk becomes like a spider’s web that spreads throughout the economy. Data collected by the Bank of International Settlements indicates that though approximately 40 percent of over-the-counter derivatives are transacted between two reporting derivatives dealers, the remaining are between those dealers and their financial and corporate customers. When the financial system failed, those risks were externalized to the public in the form of a taxpayer-funded bailout.

I believe comprehensive reform must include three key components. First, we must explicitly regulate the derivative dealers. Leading up to the financial crisis, it was assumed that the banks that deal in derivatives were already regulated, and thus did not need to be explicitly regulated for their derivative transactions. The financial crisis demonstrated that this was a flawed assumption. While banks and securities firms were regulated by their prudential regulators, their affiliates that traded derivatives were often left ineffectively regulated – that was the case for Lehman Brothers and AIG. Even though derivatives were traded inside a regulated bank, the banks were not regulated explicitly for their derivatives trading.

Second, regulatory reform must bring sunshine to the opaque over-the-counter derivatives markets. Over-the-counter derivatives are traded out of sight of federal regulators and out of sight of market participants. This was at the core of the financial crisis. We all recall in the midst of the crisis the inability to price particular mortgage derivatives. The public learned a new term – “toxic assets” – assets held by banks that were too difficult to price. Bringing transparency to the over-the-counter derivatives markets shifts the information advantage from a small group of derivative dealers on Wall Street to the broader market. This not only benefits end-users, but increases competition in the markets by lowering the barriers to entry for additional market makers and liquidity providers. A greater number of market makers also lowers risk to the system and provides greater liquidity.

We would not tolerate if other markets operated similarly to over-the-counter derivatives, where the dealer is the only one with the information. It would be like buying an apple from the supermarket when the price of the apple is kept private. How would you know if you got a fair price if you didn’t know how much the last person paid for the same apple? Further, it would be like putting 100 shares of a stock into your 401k with no knowledge of where the market prices the stocks. It is essential that we bring the benefits of a transparent marketplace to the opaque over-the-counter derivatives markets.

Third, to reduce interconnectedness in the system, standard over-the-counter derivative transactions should be moved into well-regulated clearinghouses. In the over-the-counter derivatives markets, trades are left on the books of the dealers after they are transacted. An interest rate derivative, for example, could stay on a dealer’s books for many years. As markets move, the value of those transactions change, but interconnectedness remains. The crisis showed how this interconnectedness concentrates and heightens risk to the American public.

Clearinghouses act as a middleman between two parties in an over-the-counter derivative transaction after the trade is arranged. They require derivatives dealers to post collateral so that if one party fails, its failure does not harm its counterparties and reverberate throughout the financial system. It is essential that we reduce this risk in the system. Otherwise, we could see a repeat of the financial crisis as the risk is externalized and the taxpayers are left on the hook.

I understand that improving transparency and lowering risk would mean big changes for Wall Street. We would move standardized over-the-counter derivatives out of a dealer-dominated market and into a centralized marketplace. I worked on Wall Street for 18 years with talented individuals from around the world who operated at the highest levels of professionalism. Wall Street’s interests are not always the same as the American public’s interests. In maximizing their profits, the banks are fulfilling their fiduciary duty to their shareholders, but they do not owe a similar duty to the taxpayers. We watched in 2008 when the financial system failed. It is time to change the way these markets function and the way they are regulated to benefit the public and to protect the American taxpayers.

Chairman Gensler's comments on regulating OTC derivatives - September, 2009

"...As we move forward with regulatory reform, we do so with the full knowledge of the failures of our financial regulatory system. The last decade, and particularly the last 24 months, has taught us much about the new realities of our financial markets. We have learned the limits of foresight and the need for candor about the risks we face. We have learned that transparency and accountability are essential. Only through strong, intelligent regulation can we fully protect the American people and keep our economy strong.

We have all felt the effects of the failures of our regulatory system. Every single person in this room had to put money into a company that most Americans had never even heard of. $180 billion of the tax dollars that you and I paid went into AIG to keep its collapse from further harming the economy. We must ensure that this never happens again. We cannot afford any more billion-dollar bailouts.

The need for reform of our financial system today has many similarities to the situation facing the country in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress “the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.” The Congress swiftly responded to the clear need for reform by enacting the Securities Act of 1933, the Securities Exchange Act of 1934 and the Commodity Exchange Act of 1936.

It is clear that we need the same type of comprehensive regulatory reform today. Last month, the Obama Administration, through the Treasury Department, took a crucial step of submitting legislation to Congress to apply regulation to the over-the-counter derivatives markets. The proposal is a very important step toward comprehensive regulation of both derivative dealers and the markets on which derivatives are traded. This is vital for the future of our economy and the welfare of the American people.

The Administration’s proposal will lower risk by requiring capital and margin on dealers and mandatory clearing of all standardized products. It will enhance market integrity by protecting against fraud, manipulation and other abuses and establishing new authorities to set aggregate position limits. It will promote transparency and market efficiency by requiring record-keeping and reporting for all derivatives and requiring that standardized derivatives be traded on transparent exchanges or other regulated trading platforms. As we move forward, working with Congress, to comprehensively regulate the OTC markets, we should ensure that the law covers the entire marketplace without exception.

I believe that comprehensive regulation of the OTC derivatives markets will require two complementary regimes – one for regulation of the dealers, or the actors, and one for regulation of the market, or stage.

For dealers, we should set capital standards and margin requirements to help lower risk. We should also set business conduct standards to guard against fraud, manipulation and other market abuses. We should mandate recordkeeping and reporting to promote transparency. This will cover all OTC derivatives, both standardized and customized.

This must cover all of the different products, including interest rate swaps, currency swaps, commodity swaps, equity swaps and credit default swaps, as well as the derivative products that we have not yet thought of.

We should also regulate the market functions. We should require that all derivatives that can be moved into central clearing have a requirement to be cleared through regulated central clearing houses to further lower risk. To further promote transparency, we should require that standardized OTC derivatives come onto regulated exchanges regulated transparent trading systems.

Requiring clearing and trading on exchanges or regulated transparent electronic trading systems will promote transparency and market integrity and lower systemic risks. Through clearing, firms, rather than having exposures to each other, would have a clearinghouse that provides for broader risk-taking and that subjects participants to the daily discipline of mark-to-market valuations and the daily posting of collateral.

Tens of thousands of end users will benefit from the transparency brought by moving standardized swaps onto exchanges or regulated trading platforms. This transparency should give end users better pricing on both standard products and even on customized products, as customized products would be priced in relation to the standard products traded on exchanges. While some have raised a concern that this might limit commercial risk management or even innovation in the markets, I believe that this will enhance the ability of end users to effectively manage their risk.

To fully regulate OTC derivatives, we must work with Congress to enact both of these complementary regimes. Regulating both the traders and the trades will ensure that we cover both the actors and the actions that may create significant risks.

The President's proposed legislation for derivatives regulation

Source: Regulation of OTC Derivative Markets

  • Require Central Clearing and Trading of Standardized OTC Derivatives
  • Move More OTC Derivatives into Central Clearing and Exchange Trading
  • Require Transparency for All OTC Derivative Markets
  • Extend the Scope of Regulation to Cover all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets
  • Bring Robust and Comprehensive Prudential Regulation to all OTC Derivative Dealers and other Major Participants in the OTC Derivative Markets
  • Preventing Market Manipulation, Fraud, and other Market Abuses
  • Protecting Unsophisticated Investors

Department of Justice investigation of Markit

Source: Credit Swaps Probed for Antitrust Over Trading, Clearing, Data, July 16, (Bloomberg)

"The Justice Department said it’s conducting an antitrust probe of the $28 trillion credit-default swap market that may determine if banks were anticompetitive in their use of clearinghouses to back trades.

“The antitrust division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,” Laura Sweeney, a Justice Department spokeswoman in Washington, said in an e-mail yesterday. She declined to elaborate.

The division sent civil investigative notices this month to banks that own London-based Markit Group Ltd. to find out if they have unfair access to price information, according to three people familiar with the matter. Congress plans to increase regulation of the $592 trillion over-the-counter derivatives market, which includes credit-default swaps blamed for helping worsen the biggest financial calamity since the Great Depression.

Markit provides derivative and bond data to more than 1,500 customers. It owns the most actively-traded credit swap indexes and pricing services in the market, which represents $28 trillion in underlying securities, according to the New York- based Depository Trust & Clearing Corp.

Clearinghouses, capitalized by members, insure both sides against default by the other.

Intercontinental Exchange Inc.’s ICE Trust clearinghouse is the only credit swap trade guarantor, having backed more than $1.3 trillion of the contracts since March. ICE Trust is supported by Wall Street’s largest banks, which will split profit from the venture beginning next year. CME Group Inc.’s CMDX clearing system, in partnership with Chicago-based hedge fund Citadel Investment Group LLC, hasn’t processed any trades.

The Justice Department might “be exploring big banks’ failure to deal with competing clearinghouse ventures like the CME’s,” said Craig Pirrong, a finance professor at the University of Houston.

Kelly Loeffler, a spokeswoman for Atlanta-based Intercontinental, and Mary Haffenberg, a spokeswoman for Chicago’s CME Group, declined to comment.

New York-based JPMorgan Chase & Co. is Markit’s largest shareholder, followed by Bank of America Corp. of Charlotte, North Carolina, Edinburgh-based Royal Bank of Scotland Group Plc and New York-based Goldman Sachs Group Inc., according to filings at U.K. Companies House. All four, as well as Morgan Stanley of New York, Frankfurt-based Deutsche Bank AG, Zurich- based UBS AG and others, are members of ICE Trust that will receive profits beginning 2010."

Fed's efforts to restrict oversight in '99 and '05

"... Testimony of Patrick M. Parkinson, Associate Director, Division of Research and Statistics On modernization of the Commodity Exchange Act, Before the Subcommittee on Risk Management, Research, and Specialty Crops, Committee on Agriculture, U.S. House of Representatives May 18, 1999...

The [Federal Reserve] Board believes that the application of the CEA to the trading of financial derivatives by professional counterparties is unnecessary. Prices of financial derivatives are not susceptible to, that is, easily influenced by, manipulation. Some financial derivatives, for example, Eurodollar futures or interest rate swaps, are virtually impossible to manipulate, because they are settled in cash, and the cash settlement is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply.

For other financial derivatives--for example, futures contracts for government securities--manipulation of prices is possible, but it is by no means easy. Large inventories of the instruments are immediately available to be offered in markets if traders endeavor to create an artificial shortage. Furthermore, the issuers of the instruments can add to the supply if circumstances warrant. This contrasts sharply with supplies of agricultural commodities, for which supply is limited to a particular growing season and finite carryover.

In addition, professional counterparties simply do not require the kind of investor protections that the CEA provides. Such counterparties typically are quite adept at managing credit risks and are more likely to base their investment decisions on independent judgment. And, if they believe they have been defrauded, they are quite capable of seeking restitution through the legal system. Nor is there any obvious public policy reason to foster direct retail participation in financial derivatives markets...

... Testimony of Patrick Parkinson, Deputy Director, Division of Research and Statistics, Commodity Futures Modernization Act of 2000, Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, September 8, 2005…

The Federal Reserve Board believes that the CFMA has unquestionably been a successful piece of legislation. Most important, as recommended by the President's Working Group on Financial Markets in its 1999 report, it excluded transactions between institutions and other eligible counterparties in over-the-counter financial derivatives and foreign currency from regulation under the Commodity Exchange Act (CEA).1

As the Working Group argued, regulation of such transactions under the CEA was unnecessary to achieve the act's principal objectives of deterring market manipulation and protecting investors. Such transactions are not readily susceptible to manipulation and eligible counterparties can and should be expected to protect themselves against fraud and counterparty credit losses. Exclusion of these transactions resolved long-standing concerns that a court might find that the CEA applied to these transactions, thereby making them legally unenforceable.

At the same time, the CFMA modernized the regulation of U.S. futures exchanges, replacing a one-size-fits-all approach to regulation with an approach that recognizes that the regulatory regime necessary and appropriate to achieve the objectives of the CEA depends on the nature of the underlying assets traded and the capabilities of market participants. Together, these provisions of the CFMA have made our financial system and our economy more flexible and resilient by facilitating the transfer and dispersion of risk. Consequently, the Board believes that major amendments to the regulatory framework established by the CFMA are unnecessary and unwise.

Fed's endorsement of oversight in '08

Patrick M. Parkinson, Deputy Director, Division of Research and Statistics, Credit derivatives Before the Committee on Agriculture, U.S. House of Representatives, November 20, 2008…

As noted in my earlier statement, supervisors have worked with market participants since 2005 to strengthen the infrastructure of credit derivatives markets through such steps as greater use of electronic confirmation platforms, adoption of a protocol that requires participants to request counterparty consent before assigning trades to a third party, and creation of a contract repository, which maintains an electronic record of CDS trades. Looking forward, the most important potential change in the infrastructure for credit derivatives is the creation of one or more central counterparties (CCPs) for CDS. The Federal Reserve supports CCP clearing of CDS because, if properly designed and managed, CCPs can reduce risks to market participants and to the financial system. In addition to clearing of CDS through CCPs, the Federal Reserve believes that exchange trading of sufficiently standardized contracts by banks and other market participants can increase market liquidity and transparency and thus should be encouraged.

Policy discussions of potential regulatory changes for CDS have focused on preventing market manipulation, improving transparency, and mitigating systemic risk. Manipulation concerns can be addressed by clarifying the Securities and Exchange Commission's (SEC) authority with respect to CDS. Data from a contract repository provide a means for enhancing transparency, a topic I will discuss in greater depth later. To better contain systemic risk, prudential supervisors already have begun to address the weaknesses of major market participants in measuring and managing their counterparty credit risks. This step is fundamental to containing systemic risk because it helps limit the potential for any single large market participant to be the catalyst for transmission of such risk.

Market reaction to proposals

Pretty much everyone agrees on the causes for the country’s desperate financial mess: predatory lenders, weak regulations, even weaker regulators, and risky nigh unto incomprehensible financial instruments.

Congress’s willingness to address those problems will have its first real test on Wednesday when the House Financial Services Committee puts finishing touches on what could be essential reform legislation — or a major disappointment, depending on what they do.

At the top of the committee’s agenda is regulation of the largely unregulated and dangerously opaque multitrillion-dollar derivatives’ market. Next on the agenda is the creation of a new Consumer Financial Protection Agency to oversee the consumer-credit offerings of banks and other financial firms — including mortgages, credit cards, overdraft “protection” and payday loans.

Both reforms are crucial, and we fear both are in danger of being irreparably weakened.

Derivatives are supposed to help investors and businesses manage risk, but their unchecked and unregulated use led — directly and indirectly — to the financial crash and subsequent trillions of dollars in taxpayer interventions.

Congress should require that all derivatives’ dealers and users — including banks, hedge funds and corporations — conduct their trades on exchanges where they would be subject to considerable regulation and public scrutiny. Regulators could create exceptions for customized contracts that are negotiated one on one for truly complex and unique circumstances. But most derivatives contracts are highly standardized and can be, and should be, exchange-traded.

Unfortunately, the proposed legislation has too many loopholes and exemptions. For example, many corporations and hedge funds would still be able to trade standardized derivatives privately. That may protect bank profits — without transparency, there is no chance for comparison shopping — but it would put taxpayers at risk of a repeat calamity.

Like the banks, some corporate investors in derivatives resist exchange trading. They argue that more regulation would raise their transaction costs to hedge any given risk. That’s debatable because greater transparency is likely to reduce costs. But even if true, somewhat higher costs would be a small price to pay for systemwide stability.

Attitudes to derivatives reform either side of the Atlantic appear to be diverging. While US regulators last week pushed for more stringent rules than those set out in the Treasury Bill, officials in Europe seem to be playing down broad-brush regulation in favour of a more piecemeal approach. Helen Bartholomew reports.

There is no question that derivatives markets would undergo the biggest change in their history under proposed regulatory reform, but the extent of the regulatory gap between US and European legislation threatens to be larger than many had expected. Despite calls for convergent solutions, some US officials are concerned that a softer line by their European counterparts could lead to regulatory arbitrage.

Among derivatives end-users in the US, fears are rising following last week's House Agriculture Committee hearing at which US regulators called for tougher measures than are included in the Treasury Bill. But in Europe, where legislative proposals are yet to be drafted, derivatives professionals were given some indication that the European Commission might be taking a softer line on reform.

Under the Bill proposed by US Treasury Secretary Timothy Geithner, which most believe will provide the framework for regulatory reform in the US, all standardised OTC trades would be moved on to regulated exchanges or regulated transparent electronic trade execution systems, and all trades not cleared by central counterparties would be reported to a regulated trade repository.

The two regulatory bodies – the Securities and Exchange Commission and the Commodity Futures Trading Commission – would set capital and margin requirements for industry participants and retain the right to set position limits.

"There has been an amalgam of bills over the last nine months covering derivatives reform, with three or four pieces of major legislation," said Michael Stein, global head of government relations at Morgan Stanley. "The Geithner proposal is likely to be the base for any final bill."

Under that proposal, derivatives market participants will be split into three groups: dealers, major market participants, and others. Although the definitions are yet to be determined, major market participants would probably include financial institutions that are not dealers as well as major corporate end-users.

Importantly, those users that do not fall into the dealer or major market participant categories would be exempt from new regulatory requirements for products that are not eligible to be cleared. Also, under the proposal, a number of derivative categories, including foreign currency swaps and forwards would be excluded from new regulatory oversight.

Concerned about the potential for regulatory loopholes, US regulators last week called for exemptions to be removed from any new legislation. At the House Agriculture Committee's second hearing on derivatives reform last week, CFTC chairman Gary Gensler called for more stringent regulatory powers.

"We should eliminate exclusions and exemptions from regulation for OTC derivatives," he said. "I believe that the law must cover the entire marketplace, without exception.

"Only with two complementary regimes that regulate both the derivatives dealers and the derivatives markets can we ensure that federal regulators have full authority to lower risks, promote transparency and prevent fraud, manipulation and other abuses," Gensler added.

SEC chair Mary Schapiro agreed, saying: "While Treasury's proposal would go a long way towards bringing OTC derivatives under a comprehensive regulatory framework, I believe it should be strengthened in several ways to further avoid regulatory gaps and eliminate regulatory arbitrage opportunities."

Schapiro's suggestions were echoed in a new bill introduced last week by Jack Reed, chairman of the Senate Banking Subcommittee. His proposals differ from the Treasury Bill by extending regulation to all derivatives trading, though he does not call for all instruments to be traded over a regulated platform.

European reform still lags some six months behind that seen in the US, and proposed legislation is not expected until next month. Last week, the EC held a one-day conference in Brussels to mark the end of its consultation on derivatives reform, at which internal market and services commissioner Charlie McCreevy called for convergent solutions.

Ahead of the conference, Sharon Bowles, a member of the European Parliament and chair of the economic and monetary affairs committee, told derivatives professionals in London that she did not believe derivatives to be the cause of the financial crisis.

"Derivatives were not a major factor in the crisis at all." she said. "If anything, they have performed better under stress than some other instruments."

Bowles also gave clear indications that the debate would take into account the risk profile of products, rather than taking a broad-brush approach, saying: "Where bespoke OTC products are retained and needed, proper analysis is required rather than a blanket assumption concerning their risk."

And she suggested that exemptions could to be made in some product areas such as in the foreign exchange category, where she said it might be best to "leave things as they are".

Introducing broad new legislation in Europe may be more problematic than in the US, given that securities markets are governed by the Financial Services Action Plan. The new regulatory regime looks set to be an extension of existing rules rather than the dramatic reform proposed in the US.

"There are already two pieces of legislation covering derivatives – MiFID and the Market Abuse directive – we are just looking at filling in the gaps," said Maria Velentza, head of the securities markets unit at the EC.

Legislation alone is unlikely to be the answer and the EC is exploring alternative measures to ensure that the new regime fits with existing laws.

"We favour solutions that are alternatives to legislation and may use a mix of policy tools. Where new legislation is introduced, it will be justified and subject to cost-benefit analysis," said Velentza.


Goldman Sachs Group Inc. executives said that new rules on trading over-the-counter derivatives may benefit the firm because of the company’s technological edge, according to Citigroup Inc. analyst Keith Horowitz.

Horowitz and his team raised their earnings-per-share estimates for New York-based Goldman Sachs, and said in a note to investors yesterday that they are “more optimistic” about the firm’s ability to cope with regulatory reform. The note followed meetings with Chief Financial Officer David Viniar, President Gary Cohn, Harvey Schwartz and David Heller, the co- heads of Goldman Sachs’s securities trading business, and David Solomon, co-head of the investment-banking division.

The Goldman Sachs officials “downplayed” the effect of changes to over-the-counter derivatives, commodity position limits and higher capital requirements, Horowitz wrote. The rules “may actually turn out to be a benefit for GS due to their strong technology position,” he wrote, referring to the company by its stock-ticker symbol.

According to the Citigroup analysts’ note, the Goldman Sachs management team said they’ve had “a lot of interaction” with policy makers in Washington and “they believe Washington is likely to be more balanced in the proposals than some market participants may have initially feared.”

In particular, they said Washington lawmakers see a need for both standard and customized over-the-counter derivatives, the note said. That’s “a significant step away from earlier rhetoric that called for standardization and clearing of all OTC derivatives.”

Electronic Trading

Central clearing of derivatives will rely on electronic trading, which Goldman Sachs management said plays to their advantage in technology, the note said. Management also said new minimum requirements for how much collateral and margin needs to be set aside for over-the-counter trades could help level the playing field with Goldman Sachs, which has historically had higher requirements than peers, the analysts wrote.

The Citigroup analysts said they are expecting Goldman Sachs’s revenue from fixed-income, currencies and commodities, which reached a record so far this year, to decline 15 percent to 20 percent next year. They said Goldman Sachs executives said they’re not threatened by a narrowing in the so-called bid-ask spread because they expect higher trading volume will offset the decline in profit on each trade.

“There are fewer top-tier players, so it is not surprising that more revenue will accrue to the strongest players -- which appear to be GS and JPM at the moment,” the analysts wrote, referring to JPMorgan Chase & Co., the second-biggest U.S. bank."


"... Industry analysts say that ECN-like venues that would compete with exchanges could emerge for trading credit derivatives, and that these ECNs would plug in to the various central clearing counterparties (CCPs). But there also is debate around the topic of entering all OTC derivatives into central clearinghouses.

"When this started there was a lot of talk in Congress to mandate central clearing in derivatives," says TABB's McPartland. "We've since seen a little bit of a step back and realization in D.C. that everything is not feasible for a central clearing model." McPartland adds that the Fed understands this point and could look to manage the CDS market in other ways, such as through capital requirements. Dealers already have agreed to enter any derivatives cleared bilaterally into a central data repository.

Although the word "standardized" is used numerous times in the report, McPartland argues that some of the contracts with standardized terms are not liquid and could pose a danger to the clearinghouses if one of the members were to default. For example, the CDS tranches based on the ABX index of subprime mortgages are illiquid and may have no last-trade price for several weeks, he relates. This would make it difficult for a clearinghouse to figure out what the margin should be, according to McPartland. "So while the contract terms are standard, the reality is, because of the nature of those CDSs, it would make them complicated to value, to set margin requirements and for the clearinghouse to manage their risk," he says.

Even though there is push to move bilateral OTC derivatives onto electronic platforms and central clearing facilities, according to sources who have seen the Obama administration's white paper, the government is not mandating central counterparty clearing. "You can't centrally clear exotic derivatives," notes IDX's Cawley, who adds that while 40 percent of the CDS index market and 50 percent of the single-name CDS contracts are standardized, 10 percent of the CDS market is customized. "There will always be a need to write the custom CDS or highly bespoke derivatives, but if we have a system like TRACE [Trade Reporting and Compliance Engine] to report them, then we can monitor the activity," Cawley says.

Reporting on Compliance

As a way to police the activity in OTC derivatives and prevent fraud and manipulation, the administration's proposal calls for recordkeeping and reporting requirements on all OTC derivatives and setting up a transaction reporting system, similar to TRACE in the bond markets. "That's not a problem -- firms can be forced to run end-of-day reports and send them to a repository," says TABB's McPartland. "It's not brain surgery to report trade data. It's more about how regulators are going to monitor this on a day-to-day basis and identify systemic risk." The technology exists, adds McPartland, pointing to complex event processing as a way to set rules and find patterns in many disparate sources of data.

"The Treasury is calling for a system like TRACE. Industry participants need to band together," adds IDX's Cawley. "The industry has to come up with a market data solution and an open repository for trade reporting that the industry participants have to put together." While the Obama administration has laid out its vision for revamping financial regulation, the details now will be worked out through the legislative process in Congress. Banks and dealers have hired lobbyists to influence the direction of the final rules, and heads of banks surely will be called to testify before Congress. But the worry -- particularly on the derivatives front -- is that politicians don't understand the day-to-day concerns of a buy-side trader who has a CDS portfolio, according to TABB's McPartland.

"There is definitely a disconnect between what Wall Street knows and what D.C. knows," he says. "And it's important that everybody comes together to determine the final solutions."

Source: Appetite for derivatives returns, says MF Global Financial Times, August 6, 2009

"...“The macro-drivers in our industry are starting to stabilise,” Mr Dan said. “Risk aversion is abating, the banks have been taking more risk to drive their earnings and we’re seeing greater hedge-fund and asset-manager participation. Open interest in the last two quarters has gone up. More people are taking positions.”...

...As well as economic factors, lack of clarity over the emerging shape of post-crisis US financial regulation has also weighed on investor sentiment. In spite of the continuing uncertainty over how the debate in Washington will play out, the MF Global chief said most of the proposed changes to derivatives trading – such as mandating the central clearing of over-the-counter contracts – would end up benefiting the exchange-listed broker at the expense of the big banks that are the main dealers in the privately negotiated bilateral agreements..."

Global derivatives statistics

US derivatives concentration

2Q '09 data

The notional value of derivatives held by U.S. commercial banks increased $1.5 trillion in the second quarter, or 0.7%, to $203.5 trillion.

  • U.S. commercial banks reported revenues of $5.2 billion trading cash and derivative instruments in the second quarter of 2009, compared to a record $9.8 billion in the first quarter.
  • Net current credit exposure decreased 20% to $555 billion.
  • Derivative contracts remain concentrated in interest rate products, which comprise 85% of total derivative notional values. The notional value of credit derivative contracts decreased by 8% during the quarter to $13.4 trillion.


U.S. commercial banks earned $5.2 billion trading derivatives in the second quarter, as the level of risk eased in the global market for the complex financial instruments, according to a government report released Friday.

A total of 1,110 U.S. commercial banks reported trading or holding derivatives at the end of the second quarter, up 47 from the first quarter, according to the Office of the Comptroller of the Currency, a Treasury Department agency. Still, five big banks – J.P. Morgan Chase & Co., Goldman Sachs Group Inc., Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. -- account for 97% of the total derivatives reported to be held by U.S. commercial banks.

The $5.2 billion in banks' trading revenues in the April-June period was down from a record $9.8 billion in the first quarter, but a decline had been expected and was at least partly due to seasonal changes, the agency said. The second-quarter revenues were the sixth-largest since the agency began keeping records in 1996. Banks earned a total $1.6 billion in trading revenues in the second quarter of 2008.

At the same time, the primary measure of credit risk in derivatives trading -- called net current credit exposure -- fell $140 billion, or 20%, in the second quarter to $555 billion.

The risk measure has decreased significantly over the first half of this year, "although by any standard these (credit) exposures remain very high," said Kathryn Dick, the deputy comptroller for credit and market risk, in a statement.

The narrowing of the gap between the rates at which banks are willing to lend and what borrowers are willing to pay indicates that "the [credit] market feels better about the quality" of the banks that trade in derivatives, Ms. Dick said in a conference call with reporters.

Derivatives, traded in an unregulated $600 trillion market, were partly blamed for the financial crisis that ignited a year ago. The value of derivatives hinges on an underlying investment or commodity -- such as currency rates, oil futures or interest rates. The derivative is designed to reduce the risk of loss from the underlying asset. Derivatives trading is dominated by about 20 big banks world-wide.

Credit default swaps, a form of insurance against loan defaults, account for an estimated $60 trillion of the over-the-counter derivatives market. The collapse of the swaps brought the downfall of Wall Street banking house Lehman Brothers Holdings Inc. about a year ago and nearly toppled American International Group Inc., prompting the government to support the insurance conglomerate with more than $180 billion in aid.

Contracts on interest rates and foreign exchange rates also figure prominently in the derivatives market.

Congress is weighing legislation to impose broad new oversight on derivatives. The Obama administration's proposal, part of its plan for overhauling U.S. financial rules, would subject the banks that trade derivatives to requirements for holding capital reserves against risk and other rules. A new network of clearinghouses would be established to provide transparency for derivatives trades.

Last year as the credit crisis raged, U.S. commercial banks recorded their first industrywide loss on derivatives trading. The $836 million loss compared with trading revenue of $5.49 billion in 2007, according to the comptroller's office.

The agency's second-quarter report found that the total value of derivatives held at U.S. commercial banks rose to $203.5 trillion, up by $1.5 trillion, or about 1%, from the first quarter.


Members of Congress probing threats to the global financial system — especially the threat of concentration of risk — will have a lot to ponder in newly mandated disclosures highlighted by a Fitch Ratings report issued last week. While derivatives use among U.S. companies is widespread, an "overwhelming majority of the exposure is concentrated among financial institutions," according to the rating agency's review of first-quarter financials.

Concentrated, in fact, among a mere handful of financial-services giants. About 80% of the derivative assets and liabilities carried on the balance sheets of 100 companies reviewed by Fitch were held by five banks: JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley. Those five banks also account for more than 96% of the companies' exposure to credit derivatives.

About 52% of the companies reviewed disclosed there were credit-risk-related contingent features in their derivative positions. Such features require a company to post collateral or settle outstanding derivative liabilities if there's a downgrade of the company's credit rating.

The Fitch analysts also found that just 22 companies disclosed the use of equity derivatives. Just six nonfinancial firms — IBM, General Motors, Verizon, Comcast, Textron, and PG&E — reported exposure to share-based derivatives.

For the report, the rating agency reviewed first-quarter 2009 filings of the companies, which come from a range of industries and represent almost $6.4 trillion in aggregate outstanding debt. The companies also recorded a total notional amount of derivative positions of more than $296 trillion.

Unlike the financial firms, which both use derivatives and issue them for profit, nonfinancial companies seem mostly to use derivatives just to hedge specific risks, according to Fitch. While "derivatives trading by utilities and energy companies appear to be very limited," for instance, "most of the companies reviewed in both industries report the use of derivatives for hedging commodity risks," the report found.

The first-quarter 2009 financial reports marked the first time comprehensive derivatives disclosure was mandated for all U.S. companies. "The need for better disclosure on derivatives has been obvious since the implementation of Statement of Financial Accounting Standards 133, Accounting for Derivative Instruments and Hedging Activities," according to the Fitch report. But comprehensive disclosure of derivatives wasn't part of U.S. generally accepted accounting principles for most companies until March, when the Financial Accounting Standards Board implemented SFAS 161, Disclosures about Derivative Instruments and Hedging Activities.

The latter standard is an attempt to simplify hedge accounting, perhaps the most notorious example of the complexity of U.S. financial reporting. More than 800 pages of rulemaking and guidance were needed to make sense of SFAS 133.

For its part, SFAS requires companies to improve their disclosures about how they account for and use derivatives, and how derivatives affect their balance sheets, income statements, and cash-flow statement.

"The new derivative disclosures are a welcome addition for analysts and investors, and they bring much-needed transparency to financial reporting," says Olu Sonola, a Fitch Ratings director. "The disclosures reveal plenty, but careful analysis and additional scrutiny must be applied."

In particular, users of financial statements need added information about the sensitivity of companies' derivative valuations to major assumptions, according to the ratings agency. Since risk analysts often base their derivative valuations on quantitative models, changes in significant valuation assumptions are particularly important, says Fitch.

The firm's analysts reported that perhaps "the most surprising information coming from our review of energy companies" was that Exxon Mobil — the biggest U.S. energy company — had no derivative exposure at the end of the first quarter. Instead, the company appears to rely on what's called natural hedges — countervailing trends within the corporation itself — to manage potential risks. The report cited Exxon's 2008 10-K:

"The corporation's size, strong capital structure, geographic diversity and the complementary nature of the upstream, downstream and chemical businesses reduce the corporation's enterprise-wide risk from changes in interest rates, currency rates and commodity prices. As a result, the corporation makes limited use of derivative instruments to mitigate the impact of such changes. The corporation does not engage in speculative derivative activities or derivative trading activities nor does it use derivatives with leveraged features."

Arguments for derivatives regulation

Credit derivatives such as credit default swaps (CDS) can be thought of as insurance policies that protect a lender from the risk of default by the borrower. Party A pays a premium to Party B, who agrees to pay Party A in the event Party C defaults on its obligations, such as bonds. CDS can be used to hedge or can be used speculatively. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008.[1]

Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.The Economist-"Derivatives-A Nuclear Winter?"[2]

Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulate derivatives, including credit default swaps (CDS). Clinton-Derivatives[3]

Economist Joseph Stiglitz summarized how CDS contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze." [4]

NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems...In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.[5]

Abstract:

The recent credit crisis has highlighted the lack of regulation for credit default swaps that has both magnified and contributed to market failure that began in the latter half of 2008. Securities regulation covers most types of investment contracts, but currently does not include non-securities based derivative contracts such as credit default swaps. The unique aspect of credit default swaps is that unlike other risk shifting contracts such as insurance, they are not regulated. The regulatory framework lacks a consistent approach in dealing with risk shifting and hedging devices. The degree of regulation is based on the form of the instrument rather than on the substance of the risk shifting transactions. This essay is an abridged and updated version of a 2005 article that questioned the wisdom of deregulation in the derivatives markets that has taken place since the early 1990s.

Arguments against regulating credit derivatives

Credit derivatives provide market signals regarding the risk of particular investments. For example, the cost of providing CDS protection for particular bonds is a signal regarding the risk of those bonds.

CDS also allow particular credit risks to be hedged, as an entity can purchase protection from many sources of credit risk, much like an insurance policy.

While total notional value related to CDS is enormous (estimated between $25–$50 trillion), the true exposure related to that notional value is approximately $2.5-$3.0 trillion.

This amount would only be lost if the underlying assets lost their entire value (i.e., akin to all the cars insured by car insurance companies being totaled simultaneously; CDS insure bonds instead of cars), which is outside any reasonable scenario.

Since many of these CDS provide protection against defaults of bonds in quality companies, true risk of loss related to CDS is considerably less. AEI - Wallison - Credit Default Swaps

Global oversight

Chinese derivatives rules hit global banks

"Many of the world’s biggest banks are in effect locked out of China’s small but fast-growing derivatives markets after refusing to sign new trading agreements with the Chinese institutions that control the market.

The stand-off has caused foreign banks’ share of local derivatives trading to plummet, undermining their ambitions to expand their Chinese interest rate, foreign exchange and credit derivatives operations.

China’s four largest state-owned banks control the vast majority of the onshore derivatives markets.

They are requiring locally incorporated foreign banks to secure contractual guarantees from their global headquarters to guard against trading defaults before dealing with them in the derivatives market.

The request is unprecedented and “makes a mockery of the requirement that foreign banks incorporated locally in the first place”, according to one senior China-based western banker who asked not to be named because of the sensitivity of the subject.

The demands are the latest example of how mainland officials are taking a more assertive stance towards their western counterparts after the financial crisis toppled several European and US institutions.

“They’ve asked for guarantees that are very difficult to give,” said Keith Noyes, Asia head of the International Swaps and Derivatives Association. “You have a stalemate now.”

Market participants said that, largely as a result of the stand-off, the volume of trade in renminbi/foreign exchange swaps has tumbled in recent months from the $3.4bn average per day that it was trading as recently as July.

Until then, trading volumes in foreign exchange swaps had grown rapidly after China removed its long-standing currency peg to the dollar in 2005.

Mainland banks are making their demands through the use of China’s new derivatives master agreement, which was introduced in March.

FSA on regulating OTC derivatives

Risks highlighted by the financial crisis

1.1 The financial crisis has highlighted deficiencies within the over-the-counter (OTC) derivative markets: most notably shortcomings in the management of counterparty credit risk and the absence of sufficient transparency. This paper sets out the steps required to address these issues, where relevant identifying further necessary work streams.

1.2 In summary, the Treasury and the FSA (‘UK Authorities’) propose that the following measures need to be implemented and/or developed to address systemic shortcomings in OTC derivative markets:

  • Greater standardisation of OTC derivatives contracts. Greater standardisation would enhance the efficiency of operational processes; facilitate the increased use of central counterparty (CCP) clearing and trading on organised trading platforms, and support greater comparability of trade information.We will work with international regulators and the industry to take steps to identify and agree which products can be further standardised, both in terms of underlying contract terms and operational processes, and ensure that this is implemented on a timely basis.
  • More robust counterparty risk management. All OTC derivative trades, whether or not centrally cleared, should be subject to robust arrangements to mitigate counterparty risk. For all financial firms this should be through the use of CCP clearing for clearing eligible products. For trades which are not centrally cleared these should be subject to robust bilateral collateralisation arrangements and appropriate risk capital requirements. This approach may differ for non-financial firms given the different nature of the risks they pose to the financial system.

It is important that all participants bear the cost of managing the risk they pose.

Consistent and high global standards for Central Counterparties (CCPs).

Increased use of CCPs will heighten their systemic importance so it is crucial that they are regulated to high standards, consistently applied in the major jurisdictions.

We are working in CPSS-IOSCO and the Basel committees to revise existing standards. In Europe, the UK has been leading calls for a Clearing Directive and will press to ensure this is an effective tool in mitigating any risk that CCPs will pose to the financial system.

  • International agreement as to which products are ‘clearing eligible’. This will require

assessment by both regulators and CCPs in deciding which products are eligible for clearing. In addition to the degree of standardisation, consideration must also be given to the regular availability of prices; the depth of market liquidity; and whether the product contains any inherent risk attributes that cannot be mitigated by the CCP. Once clearing eligible products are identified, regulators should set challenging targets for CCP usage with active monitoring of progress against these rather than mandate the use of CCP clearing.

  • Capital charges to reflect appropriately the risks posed to the financial system. These should be higher for non-centrally cleared trades and we are working through the Basel Committee to deliver a proportionate approach. Capital charges for exposures to CCPs should also be risk-based.
  • Registration of all relevant OTC derivative trades in a trade repository. This will facilitate regulators having appropriate access to the information they need to fulfil their regulatory responsibilities. We are working through the OTC Derivative Regulators Forum (ORF) to deliver this across a number of asset classes.
  • Greater transparency of OTC trades to the market. Access to better information around prices and volumes can help price formation and market efficiency. However, this should be calibrated to minimise scope for an adverse impact on liquidity, and consideration should be given to using existing reporting channels to minimise costs.
  • On-exchange trading. Once these steps have been taken we do not see at this stage the need for mandating the trading of standardised derivatives on organised trading platforms. Regulatory objectives of reducing counterparty risk and improving transparency can be achieved by other means and we will review progress of initiatives in this area. Moreover, mandating the use of organised platforms would imply a regulatory imposition of trading structure, which we do not believe is necessary.

1.3 This paper sets out our detailed thinking on each of these key issues as well as outlining our approach for taking these measures forward.

UK opposes mandatory exchange trading of derivatives

Banks should not be forced to shift privately-negotiated derivatives transactions onto exchanges, Britain’s Financial Services Minister, Paul Myners, said on Tuesday.

“We do not see the need for mandating trading of standardised derivatives on organised trading platforms,” Myners told a committee of parliament’s upper chamber.

The G20 group of countries agreed last year that standardised over-the-counter derivatives should be centrally cleared and, where appropriate, traded on an exchange or other type of electronic platform.

This is seen as cutting risk and increasing transparency in a sector whose opaqueness alarmed regulators during the height of the financial crisis.

U.S. insurer AIG, which nearly collapsed, and Lehman Brothers bank, which went bust in 2008, were both closely linked to the derivatives sector.

The European Union and United States are putting the G20 pledges into law but the latter is pushing hard for exchange trading of OTC contracts, which has pleased some exchanges but alarmed dealers and customers.

Myners said it was important to have a coordinated global approach to derivatives to avoid banks playing one jurisdiction against another.

Several central counterparties are emerging or set to emerge to clear the vast $450 trillion over-the-counter derivatives market, such as ICE <ICE.N> in Europe and the United States.

New EU rules would enable new central counterparties authorised in one member state to operate across the 27-nation bloc, ensure high governance standards and rights of access to all users, Myners said.

Britain sought to fend off any fresh attempts to centralise authorisation of central counterparties in the EU where financial supervision is being overhauled.

“Responsibility for authorisation and supervision of central counterparties should remain at the national level. Central counterparties will be of increasing systemic importance,” Myners said.

Big companies like airlines say hedging some risks such as fuel prices can only be done through bespoke OTC contracts that cannot be centrally cleared let alone exchange traded.

The EU’s executive European Commission has signalled that it will accommodate this by slapping capital charges on OTC trades that are not centrally cleared.

Myners said it was essential not to make it difficult for companies to hedge risks through privately-negotiated derivatives contracts due to penal capital charges.

The European Commission is due to publish a draft law on derivatives clearing by July which will need approval from member states and the European Parliament to take effect.

EC delays derivatives reform proposals to 2010

"Further reform of the over-the-counter derivatives market expected from the European Commission (EC) tomorrow is likely to take the form of soft recommendations rather than legislative proposals and could be delayed until later in the week, according to an EC official.

The EC published a communication on possible reforms on July 3, to include greater use of central counterparties (CCPs) for clearing OTC derivatives and central data repositories, as well as a possible push towards exchange trading. Having received 99 responses to its industry consultation, the EC held a conference in Brussels on September 25 and said it would work to come up with "operational conclusions" on October 20.

But the EC's formal mandate is due to end on October 31, after which it will assume a caretaker position until the New Year, meaning it cannot legally undertake new initiatives but will simply manage day-to-day business. Consequently, there is not enough time for the EC's internal market and services directorate-general, headed by Charlie McCreevy, to put its ideas into legislative practice. The next commission is expected to take office early in 2010, but the exact date will depend on the resolution of continuing disputes over the Lisbon Treaty.

"This week's statement will be a communication, which means setting out options to be taken rather than a legislative text. It will obviously be based on feedback from the consultation, but of course the bigger question in the near future will be whether we go for strong legislation on this in Europe. That will be a question for the next commission to answer," says a spokesman for Charlie McCreevy. He adds the communication will be discussed at a meeting of the EC on October 20, and will be published at the earliest that evening, but more probably on October 21 or 22.

Dealers and end-users have voiced concern over some aspects of the EC's proposals, including the suggestion incentives may be put in place to encourage the clearing of contracts through CCPs. Some have suggested there could be a moral hazard if regulators push greater volumes towards CCPs, which in turn would have a commercial incentive to clear as much as possible. Rather than mitigating risk, this could just concentrate risk on a single entity and make the CCPs systemically threatening.

The establishment of the OTC Derivatives Regulators’ Forum

"International regulators announced today the establishment of the OTC Derivatives Regulators’ Forum. Since January 2009, international regulators have been meeting periodically to exchange views and share information on developments related to central counterparties (CCPs) for over-the-counter (OTC) credit derivatives (CDS).1 Based on the success of this cooperation, the OTC Derivatives Regulators’ Forum has been formed to provide regulators with a means to cooperate, exchange views and share information related to OTC derivatives CCPs and trade repositories. The objectives of the Forum are to:

  • Provide mutual assistance among the regulators in carrying out their respective authorities and responsibilities with respect to OTC derivatives CCPs and trade repositories, and with respect to the broader roles and implications of these infrastructures in the financial system;
  • Promote consistent public policy objectives and oversight approaches for OTC derivatives CCPs and trade repositories, including the development of international cooperative oversight arrangements that may be applied to individual systems;
  • Adopt, promote, and implement consistent standards, such as the CPSS-IOSCO Recommendations for Central Counterparties (RCCPs), in setting oversight and supervisory expectations;
  • Coordinate the sharing of information routinely made available to regulators or to the public by OTC derivatives CCPs and trade repositories;
  • Effectively deal with common issues collectively and consistently; and
  • Encourage strong and open communication within the regulatory community and with the industry.

The OTC Derivatives Regulators’ Forum is comprised of international financial regulators including central banks, banking supervisors, and market regulators, and other governmental authorities that have direct authority over OTC derivatives market infrastructure providers or major OTC derivatives market participants, or consider OTC derivative market matters more broadly. See appendix 1 for a list of regulators and authorities currently involved in the Forum.

Appendix 1 – Authorities Currently Involved in the OTC Derivatives Regulators’ Forum

European Commission oversight

Source:Media release from the EU

The European Commission has adopted a Communication on ensuring efficient, safe and sound derivatives markets, following a commitment made in the Communication on 'Driving European recovery' (IP/09/351 ).

The Communication looks at the role played by derivatives in the financial crisis and at the benefits and risks of derivatives markets, and assesses how risks can be reduced. Following the public consultation which this Communication launches, the Commission will host a public hearing on 25 September 2009.

Taking into account the outcome of the consultation, the Commission will draw operational conclusions before the end of its current mandate and present appropriate initiatives, including legislative proposals as justified, before the end of the year to increase transparency and ensure financial stability.

This Communication marks another step in the Commission's efforts to strengthen the financial system in view of the failings unearthed by the financial crisis. It responds to the commitment contained in the Communication of 4 March and is fully in line with the principles adopted by the G20 and the recommendations of the de Larosi è re Group.

The Commission stands ready to work with authorities around the world to ensure global consistency of policy approaches and to avoid any risk of regulatory arbitrage.

Internal Market and Services Commissioner Charlie McCreevy said "Derivatives markets play an important role in the economy but the crisis has shown that they may harm financial stability. As regards credit default swaps (CDS), industry has committed to clear CDS on European reference entities and indices on these entities through one or more European CCPs by 31July 2009. I expect industry to move clearing of CDS to any European CCP that has received regulatory approval for clearing indices and single names by that deadline."

Taking into account the wide diversity of 'over the counter' (OTC) derivatives markets, the Communication outlines the tools to ensure that they do not harm financial stability. These tools, which can be combined with each other, are:

Standardisation

This would enhance operational efficiency and reduce operational risks. It could be achieved by encouraging broader take up of standard contracts and electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes. This requires investments and it may therefore be necessary to incentivise these investments.

Central data repositories

Such repositories collect data on, for example, number of transactions and size of outstanding positions. This increases transparency, knowledge and contributes to operational efficiency. Currently, such a repository exists for Credit Default Swaps (CDS)] 1 , and could potentially be used for other derivatives segments as well. European securities regulators (CESR) are currently carrying a feasibility study for data repository based in the European Union. In the light of the forthcoming CESR report, the Commission will decide on appropriate actions.

Central Counter-party (CCP) clearing

CCPs have proven their worth during the financial crisis. In view of those benefits, the Commission has since October 2008 worked with industry to ensure that clearing of CDS takes place on European CCPs. Industry has as a result committed to achieve CCP clearing by 31 July 2009. If industry is unable to deliver on this commitment, the Commission will have to consider other ways to incentivise the use of CCP clearing. The Commission also considers that the broader use of CCPs in other OTC derivatives markets should be incentivised, wherever possible.

Trade execution on public trading venues

For standardised derivatives that are cleared by a CCP, the question arises whether the trading of these contracts should take place on an organised trading venue where prices and other trade-related information are publicly displayed (e.g. a regulated market). This would improve price transparency and strengthen risk management. However, it could come at a cost in terms of satisfying the wide diversity of trading and risk management needs.

The Commission will examine, taking into account the bespoke and flexible nature of OTC derivatives markets and the regime applicable to cash equities, how to arrive at a more transparent and efficient trading process for OTC derivatives. In this respect the Commission will further assess

  • (i) the channelling of further trade flow through transparent and efficient trading venues and
  • (ii) the appropriate level of transparency (price, transaction, position) for the variety of derivative markets trading venues.

The Communication also highlights the actions already undertaken in response to the financial crisis in the area of derivatives (e.g. CCP clearing for CDS, securitisation, credit rating agencies and hedge funds and other alternative investment management funds, supervision).

The Commission services have also issued two Staff Working Papers. The first one analyses OTC derivatives markets and the second one is a consultation document containing a more detailed questionnaire. The consultation will be open until 31 st August 2009. Responses can be addressed to markt-g2-consultations@ec.europa.eu.

China’s state-owned enterprises may terminate contracts

Some of China's biggest airlines and shippers lost hundreds of millions of dollars last year on derivative trades when the price of oil plunged. They are now seeking to claw back those losses.

In a statement on its website, the state-owned Assets Supervision and Administration Commission said it supported moves by unnamed Chinese enterprises to seek recourse for their losses in structured financial derivative contracts tied to the price of oil and reserved the right to file lawsuits itself.

"The move is a very normal action for enterprises to use legal tools to protect their deserved rights in commercial activities," said the one-paragraph SASAC statement.

The commission is Beijing's umbrella organisation responsible for companies owned by the central government, including 150 major state-owned enterprises.

With concern already rising in recent weeks that Beijing might challenge the fuel-derivative losses, bankers have been scurrying to protect themselves.

One day last week, trading in certain contracts all but shut down in China, bankers say. Now, bankers are discussing how to impose stiffer collateral requirements for Chinese airlines and other companies that seek derivative contracts.

"It significantly increases the cost for Chinese airlines," one person familiar with the matter said of the effort to require more collateral.

The statement is the latest reminder of how Beijing is ready to adopt forceful methods to support its resource-hungry companies.

Last month, Shanghai police formally arrested four employees of Anglo-Australian miner Rio Tinto on suspicion they illegally procured information to use in negotiating a multibillion-dollar deal to supply Chinese steel makers with iron ore.

In early August, China Eastern Airlines, Air China and China Ocean Shipping sent letters to six international investment banks warning that certain transactions "may be void, invalid or unenforceable," said a person familiar with the letters.

Among the banks understood to have received such letters are Deutsche Bank, Goldman Sachs Group, JPMorgan Chase, Citigroup and Morgan Stanley, according to three people familiar with the situation.

China Eastern entered into complex deals called "collar structures" designed to keep fuel prices within a range and which included buying and selling a basket of options. When oil prices unexpectedly plunged last year along with other financial markets, the airline faced deep losses, according to disclosures by the company and bankers familiar with the matter.

The Shanghai-based carrier said in January it faced a loss of about $US900 million ($1.05 billion) on aviation-fuel-hedging activities. In a reminder of how volatile financial markets can be, it more recently said its position had reversed.

China Eastern chairman Liu Shaoyong declined to comment on the government statement but said he expects Beijing to issue new rules on the use of derivatives. He noted that hedging is a "normal" business activity. Air China and China Ocean Shipping also declined to comment.

Lawyers said Beijing's statement is startling. The government is "actively encouraging Chinese state-owned companies to cut their losses by taking various actions, including legal actions," said Alan Wang, a partner at Freshfields Bruckhaus Deringer.

By stepping into oil-derivative contract disputes that have been bubbling for months, Beijing is sending a signal that its strategic interests can extend to foreign financial markets.

That is important because as Chinese companies go abroad to procure commodities, global banks are finding big new customers for hedging contracts and other derivatives deals that aim to capture profits, offset losses and offer stability to the purchase deals.

Chinese leaders are concerned that state-owned companies, stepping outside the protective walls of the government-planned economy in search of natural resources overseas to power their rapid expansion, are easy targets for globally savvy resources suppliers and financial institutions.

The SASAC highlighted in its statement that it is investigating the oil contracts in order to "safeguard state assets," while noting the "risks and complexities" in some contracts that make them difficult to understand.

When financial markets have tripped up state companies in the past, Beijing has sometimes sought to distance itself from obligations.

Five years ago, a Chinese trading firm in Singapore lost $US550m on trades in fuel contracts. Shortly afterward, the SASAC and the trading firm's parent company, state-owned China Aviation Oil Holding, issued statements saying any losses were the fault of the Singapore subsidiary and called on counterparties to be "realistic" in their expectations of repayment.

About two years ago, the Chinese company settled its claims, paying less than estimates of the initial losses, a lawyer involved in the case said.

The government statement reiterates warnings that Chinese companies are permitted to enter derivative contracts only to hedge, or protect themselves from swings in commodity prices, and not to speculate. The policy is backed up by numerous rules, which bankers said could be tightened further.

Some in the industry believe that foreign banks will face pressure to offer derivatives through domestic Chinese financial institutions, presumably so their activity could be better monitored by Beijing. Already, China has made vigorous efforts to bring more such activity onshore through Chinese commodity markets and over-the-counter trading regulated domestically.

Financial policy makers in China say government leaders often don't grasp how derivative products work and then react angrily when deals backfire.

Mr Wang at Freshfields said the recent events highlight the need for foreign institutions to ensure that Chinese entities have necessary authorisation to enter a deal, since legal challenges are often grounded in an argument that the deals weren't permitted or were too complex.

Also, contracts should specify that disputes will be settled via international arbitration, since China won't typically enforce foreign court decisions."

"China’s state-owned enterprises may unilaterally terminate commodities contracts as they try to cut massive losses from financial derivatives, an industry source told Caijing on August 28.

According to the source, China’s State-owned Assets Supervision and Administration Commission (SASAC) has sent notice to six foreign financial institutions informing them that several state-owned enterprise will reserve the right to default on commodities contracts signed with those institutions.

Keith Noyes, an official with the International Swaps and Derivatives Association, a trade organization, confirmed that he is aware of the SASAC letter, but provided no further comment.

Foreign brokerages usually work through their Hong Kong operations to sign over-the-counter derivative hedging contracts, according to an investment banker whose firm is involved in the business. Hong Kong and Singapore usually serve as venues for arbitration over such transactions.

Most investment banks may "just swallow" any losses arising from canceled contracts, the executive said, adding that any losses are usually made up for with compensating trades.

Investment banks "just earn less" from such transactions, he said.

But any such move would be a major blow to investment banks which service massive commodities hedging operations for Chinese SOEs on the international market, said the executive.

Chinese SOEs have suffered massive losses from hedging contracts since the onset of the global financial crisis. SASAC and the National Auditing Office has been investigating derivatives positions trading since the beginning of the year.

A source from a state-owned company told Caijing that most of China’s SOEs engaging in foreign exchange and international trade have participated in derivatives trading, involving capital topping 1 trillion yuan."

Islamic banks restricted from using derivatives

"... Islamic banks have grown substantially in recent years, with their assets currently estimated at close to $850 billion. Overall, the risk profile of Islamic banks is similar to conventional banks in that the risk profile of Shariah-compliant contracts is largely similar to that in conventional contracts, and credit risk is the main risk for both types of banks.

Unlike conventional banks, however, Islamic banks are not permitted to have any direct exposure to financial derivatives or conventional financial institutions’ securities—which were hit most during the global crisis.

An analysis of the top 50 banks in the GCC indicates that conventional banks also had this advantage going into the crisis—direct exposure to equity investments (and derivatives in the case of conventional banks) were very low in both types of banks (a mere 1 percent of total assets in conventional banks and 2 percent for Islamic banks in 2008). "

India bans SocGen and Barclays from derivatives market

"Societe Generale SA’s Indian unit was ordered to stop selling or trading offshore derivatives by the nation’s capital markets regulator, which said the bank failed to provide fair and complete information about its trades.

The Securities & Exchange Board of India gave Societe Generale, France’s second-largest bank, 30 days to reply or file an objection to the order, according to a statement posted on its Web site yesterday.

The Paris-based company is the second overseas bank to be suspended from trading derivatives by the regulator in just over a month. Barclays Plc suspended sales of its exchange-traded notes linked to Indian stocks following a Dec. 9 order. Both banks gave incorrect details on the sale of so-called participatory notes, the regulator said.

“Societe Generale completely failed in obtaining correct and complete information from the counterparties it deals with,” the regulator’s statement said. “Societe Generale is required to show cause as to why appropriate proceedings including cancellation of its certificate of registration as a foreign institutional investor should not be initiated.”

The French bank said in a statement that it’s “cooperating fully” with the investigation and aims to provide all the information required within the 30-day period demanded by the regulator. Melody Jeannin, a spokeswoman in Paris, declined to comment beyond the statement.

Reliance Shares

Jonathan Williams, Barclays Capital’s Singapore-based spokesman, didn’t answer calls made to his mobile phone after hours. Barclays said on Dec. 9 that it was cooperating fully with the regulator.

Both banks reported incorrect data on transactions involving instruments linked to shares of Reliance Communications Ltd. to Hythe Securities Ltd., according to the regulator’s statements..."

The Boca Resolution

Source: [6] CFTC, 1996, amended in 1998

Declaration on Cooperation and Supervision of International Futures Markets and Clearing Organisations.

1.1. This Declaration is made in the light of, and to augment, the Memorandum of Understanding and Agreement executed contemporaneously at Boca Raton, Florida on March 15, 1996 (the “MOU”) by certain futures exchanges and clearing organizations (“Parties”).

1.2. Each of the supervisory authorities that is an initial signatory to this Declaration or that subsequently adheres to it (the “Authorities”), exercises governmental responsibilities in supervising and/or otherwise acting in respect of, a futures exchange or clearing organization.

1.3. The Authorities endorse the MOU as an effective measure to facilitate and strengthen the sharing of relevant information between Parties in order to improve their cooperation, particularly in respect of potential hazards to the stability, safety and soundness of the international financial markets.

1.4. The Authorities further endorse the recognition in the MOU that the Parties can assist each other in the discharge of their respective supervisory duties as market authorities, and in some cases as self-regulatory ecognizeons, by sharing information as described. They note the requirements in the MOU to frame requests in the event of certain triggering events or conditions to secure the specific information necessary to respond to particular events and developments, and the commitment to continued dialogue and information exchange. They believe that the provisions in the MOU to ensure appropriate confidentiality and use of information received will encourage the effective functioning of the arrangements set out in the MOU. They also welcome the acknowledgement that Parties may ask their supervisory Authority to make information available to another Party’s supervisory Authority where appropriate.

1.5. The Authorities also ecognize that the Parties may be impeded by laws or circumstances from being able to provide the necessary information directly. In desiring generally to promote the sharing of information necessary to strengthen regulatory supervision, ecogniz systemic risk, prevent or limit potential abusive or manipulative practices and enhance customer and investor protection, the Authorities hereby intend, by use of the most appropriate lawful means at their disposal, to seek to assist Parties by communicating directly with an appropriate counterparty wherever possible and appropriate in their efforts to provide the information required.

1.6. The Authorities accordingly establish the following machinery to carry these purposes into effect.

Lehman bankruptcy court says swap agreement unenforceable

When Lehman Brothers Holdings, Inc. filed for bankruptcy protection on September 15, 2008, Lehman (directly and through its subsidiaries and affiliates) was party to more than 900,000 derivative contracts. Termination of these contracts may require Lehman or its counterparties to make lump-sum termination payments to the other. As Lehman accelerates its efforts to liquidate and monetize as many of these contracts as possible, the first handful of swap-related cases have made their way onto the bankruptcy court docket, which has now become a forum to test the scope and limits of many of the "safe harbor" provisions afforded to swaps, derivatives and other financial contracts under the Bankruptcy Code. Never have so many contracts come under such intense legal scrutiny for the first time, at one time, in the same court.

A number of counterparties to Lehman have commenced adversary proceedings seeking to adjudicate their rights under these agreements, and Lehman has filed a number of motions to collect unpaid amounts it believes are due under these agreements. On September 17, in one such closely watched matter, U.S. Bankruptcy Judge James Peck ordered Metavante Corporation ("Metavante"), a counterparty to Lehman Brothers Special Financing ("LBSF") in an interest rate swap transaction in which Lehman Brothers Holdings, Inc. ("LBHI") is the credit support provider, to perform its obligations to pay quarterly fixed amounts owing under the transaction, notwithstanding the bankruptcies of LBSF and its parent. Judge Peck concluded that Metavante could not rely solely on the filing of the Lehman bankruptcy cases to refuse to make payment to Lehman while also not terminating the agreement. More specifically, Judge Peck found that:

  • the swap agreement is "in fact, a garden variety executory contract, one for which there remains something still to be done on both sides," and as such is "enforceable by a debtor against the counterparty;"
  • the safe harbor provisions available to swap counterparties under Sections 560 and 561 of the Bankruptcy Code are limited to the counterparties' right (i) to liquidate, terminate or accelerate its contracts or (ii) to net out its positions; and
  • Metavante's reliance on the standard condition precedent provision of Section 2(a)(iii) of the ISDA Master Agreement to excuse its payment indefinitely due to Lehman's bankruptcy was counter to Congress's intent to allow for "prompt closing out" and "immediate termination for default."

Ultimately, Judge Peck stated that, by 11 months after the commencement of the case, the failure to exercise the right to terminate the swap "constitutes a waiver of that right." Under his interpretation, counterparties risk waiving their rights to terminate their contracts if they fail to exercise their rights "fairly contemporaneously with the bankruptcy filing." As this is the first time the issue has been addressed by a U.S. court, the ruling may have widespread ramifications not only for other outstanding Lehman transactions but for the rights of all parties to derivatives transactions prospectively.

Who Is "In The Money" And Who Is "Out Of The Money"?

As noted earlier, the timely settlement and liquidation of outstanding derivatives transactions constitute one of the primary objectives of the Lehman bankruptcy estates. By Lehman's own count, as of June 2009, there were still hundreds of outstanding swaps and other derivatives contracts in which Lehman was "in the money" (i.e., it would be owed a payment upon early termination rather than being required to make one). The "out of the money" counterparties face difficult decisions as a result of the bankruptcy cases. Under the terms of the ISDA Master Agreement1 under which the vast majority of these transactions are documented, the counterparty, as the non-defaulting party, has the right (but not the obligation) to terminate a transaction early or to let it continue.

A transaction that is out of the money for a counterparty today may be in the money tomorrow, or at least at sometime prior to its scheduled termination date. Accordingly, the dilemma for these counterparties has been whether or not to continue to perform on these contracts, making payments to Lehman as and when required, in the hope that Lehman might be able to satisfy its obligations at such future time that the markets would move in the counterparties' favor. With Lehman in Chapter 11, many counterparties may have concluded that Lehman was unlikely to ever be in a position to perform and therefore elected (i) not to terminate their transactions, but also (ii) to withhold any required periodic payments to Lehman in reliance on Section 2(a)(iii) of the Master Agreement. Section 2(a)(iii) provides that the obligation of a party to perform under a transaction is subject to the condition precedent that "no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing."

Whether, and for how long, a non-defaulting party may exercise these "wait and see" rights is a question that had not been addressed by a U.S. court2 before the Lehman bankruptcy cases, but was among the issues that Judge Peck considered in Metavante.

The Metavante Decision

In November 2007, Metavante entered into an amortizing interest rate swap transaction with LBSF with a notional amount of $600 million under which LBSF, as floating amount payer, agreed to make quarterly payments based on a floating interest rate. Metavante, as the fixed amount payer, agreed to make payments based on a fixed interest rate. Under the transaction, the swapped payments were netted, as is customary, and only the party with a net payment obligation was required to pay the other party on each payment date. The transaction was documented in a 1992 ISDA Master Agreement and customary trade confirmation. LBSF's obligations were unconditionally guaranteed by LBHI.

On September 15, 2008, LBHI filed for bankruptcy under Chapter 11 of the Bankruptcy Code. Shortly thereafter, on October 3, 2008, LBSF commenced its own Chapter 11 bankruptcy case. Under Section 5(a)(vii) of the Master Agreement, the bankruptcy filings by LBHI and LBSF each constituted a separate event of default by Lehman, each of which entitled Metavante, as the non-defaulting party, to designate an early termination date for the transaction if it so chose. Upon early termination, the Master Agreement generally provides for the transaction to be valued in light of current market rates and otherwise in accordance with certain payment measures and methods specified in the contract. The party determined to be out of the money based on those calculations must make a termination payment to the other party, regardless of which is the defaulting party. Based on Lehman's and Metavante's filings in the proceeding, upon an early termination of the swap, Metavante would likely have been obligated to make a significant lump-sum payment to LBSF.

In reliance on the "wait and see" provision of Section 2(a)(iii) of the Master Agreement, Metavante chose to neither terminate nor perform. Based on Lehman's and Metavante's filings in the proceeding, Metavante owed periodic net payments to LBSF under the swap transaction but Metavante had not made any of these payments since the Lehman bankruptcy filings.

In May 2009, Lehman filed a motion to compel performance of Metavante's obligations, asserting that the swap was an executory contract and arguing for a "straightforward application" of Section 365 of the Bankruptcy Code. Specifically, Section 365(e)(1) of the Bankruptcy Code prevents parties from modifying rights of a debtor under an executory contract "at any time after commencement of the case solely because of a provision in such contract . . . that is conditioned on . . . the commencement of a case under this title . . . ." Lehman argued therefore that Section 2(a)(iii) of the Master Agreement was void and unenforceable as an ipso facto clause because permitting a party to indefinitely delay performance in reliance on that provision effectively modified LBSF's rights solely as a result of the commencement of the bankruptcy cases.

In its motion, Lehman acknowledged that the Bankruptcy Code provides for a safe harbor that exempts the exercise by a swap participant (or certain other derivative contract counterparties) of "any" contractual right arising under a swap agreement (or other derivative contract) and permits a swap participant, among other things, to "offset or net out any termination value, payment amount, or other transfer obligation" under any related transaction.3 While the scope of the safe harbor is expansive in terms of the types of covered transactions, Lehman argued that the safe harbor itself is limited to exercise of the stated remedies only (i.e., liquidate, terminate, accelerate and offset) and did not [give] license [to] other modifications of the debtor's rights by counterparties.

Conversely, Metavante argued that the terms of the Master Agreement were clear and unambiguous: the non-defaulting party had the right, but not the obligation, to terminate all outstanding transactions, and Section 2(a)(iii) permitted the non-defaulting party to suspend its performance while an event of default was continuing, with no applicable time limit. In its filings, Metavante declared that the "right to elect to terminate – or not terminate – the swap at any time prior to maturity is an essential and critical right of a non-defaulting party."4 Metavante further noted that a ruling in favor of Lehman's motion would deprive it of its rights to net/set-off any damages arising from the termination since the non-defaulting party has the right of set-off only upon its designation of an early termination date on account of the other party's default.

Judge Peck sided with Lehman. In granting the motion, he concluded that the safe harbor provisions of the Bankruptcy Code "protect a non-defaulting swap counterparty's contractual rights solely to liquidate, terminate or accelerate" derivatives transactions upon the bankruptcy of their counterparty, or to "offset or net out any termination values or payment amounts" in connection with such a termination, liquidation or acceleration. By "simply withholding performance," Metavante was not attempting to take any of these actions and was thus not protected by the Bankruptcy Code safe harbors. Judge Peck then found that the contract between Metavante and Lehman was a "garden variety executory contract," subject to the general executory contract principles of the Bankruptcy Code.

Finally, though the Bankruptcy Code itself is silent as to a time-frame within which a non-defaulting counterparty must act to exercise its termination and other rights contemplated under the safe harbor, Judge Peck held that "Metavante's window to act promptly under the safe harbor provisions has passed, and while it may not have had the obligation to terminate immediately" upon Lehman's bankruptcy filing, its failure to exercise its statutory rights at this point in the case had resulted in a waiver of those rights.

LOOKING AHEAD

There are many other derivative and financial contract transactions either pending before the Lehman bankruptcy court or that have yet to be brought before the court – some similar to Metavante and others with minor or major variations on the facts. For example, on August 27, 2009, the Board of Education of the City of Chicago filed a complaint seeking a declaratory judgment in connection with its own interest rate swap with LBSF, under which LBHI was the guarantor as well. The Board of Education similarly has not made payments otherwise required to be made by it under its swap contract and it too is relying at least in part on the "wait and see" provision of Section 2(a)(iii).

its complaint, the Board of Education adds that the primary event of default upon which it is relying is not the bankruptcy filing by LBSF, its counterparty, but the pre-petition event of default that occurred when LBHI, as guarantor, failed to pay its debts as they became due and filed for bankruptcy protection. The Board of Education is arguing at least initially that Section 365(e) of the Bankruptcy Code, which prohibits contracts from containing an event of default conditioned solely upon the financial condition of the debtor, is inapplicable to its contract with Lehman because the relevant event of default relates to the financial condition of the guarantor, LBHI. Whether the Bankruptcy Court will be more receptive to this argument (which appears to be equally applicable to the facts of Metavante) remains to be seen.

The court's rulings in Metavante also evoke a number of questions. For example, first, embedded in the decision without significant discussion is the finding that a swap is a "garden variety" executory contract and not a contract for "financial accommodation" that would preclude application of the executory contract principles under Section 365. Second, while the Bankruptcy Court's ruling indicates that 11 months is long enough to constitute a waiver of a non-defaulting party's right to terminate outstanding transactions upon the other party's default, the court did not answer the question as to when such a waiver actually occurred or became effective.

Neither the relevant safe harbor provision of the Bankruptcy Code nor Section 365 of the Bankruptcy Code addresses this issue, directly or indirectly. Third, it remains an open question as to whether other events of default or potential events of default (i.e., defaults other than those arising from the filing of a bankruptcy case) would be sufficient to excuse payment in reliance Section 2(a)(iii) of the Master Agreement. Nuances in facts and interpretations may give rise to additional questions, of course, especially as the court continues to address similar cases.

The Lehman cases may offer answers to these and other questions for those parties that come before the court with different contractual arrangements. More of these disputes are scheduled to be heard on October 15, 2009. If Lehman or any of its counterparties appeals an adverse ruling, then additional guidance may develop. Finally, market participants will closely observe the results in these cases and perhaps reconsider the Master Agreement forms in light of what has occurred. The sheer quantity and complexity of transactions to which Lehman was a party makes the Lehman bankruptcy cases a testing ground for the treatment of derivative financial contract agreements under the Bankruptcy Code and will certainly impact how these agreements are negotiated long into the future.

Footnotes

1. The ISDA Master Agreement is published by the International Swaps and Derivatives Association, Inc. While there are two versions of the Master Agreement currently in use, the 1992 and 2002 forms, the provisions of the Master Agreement discussed in this Alert (Sections 2(a), 5 and 6) are substantially similar as between the two versions.

2. In a widely reported 2003 Australian case, Enron Australia v. TXU Electricity Ltd, the court declined to depart from the plain meaning of the provision, permitting TXU to withhold performance under Section 2(a)(iii) indefinitely. Specifically, the court found that the bankruptcy laws did not permit it "to deprive the counterparty of its contractual rights, such as the right not to designate an Early Termination Date . . . and the right under section 2(a)(iii) not to make a payment."

3. Absent these safe harbor provisions, the Bankruptcy Code would preclude swap participants (or certain other derivative contract counterparties) from liquidating agreements or realizing against any property posted as collateral (without first obtaining relief from the automatic stay in bankruptcy court).

4. Objection of Metavante Corporation to Debtors' Motion pursuant to Sections 105(a) and 365 of the Bankruptcy Code, to Compel Performance of Obligations under an Executory Contract and to Enforce the Automatic Stay at 13 (June 15, 2009).

Lobbying for derivatives

See Derivatives lobbying.

Derivative accounting standards

See Derivatives accounting

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:

  • Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary.

Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.

The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other often sophisticated parties, such as hedge funds.

Reporting of OTC trade amounts can occur in private, without activity being visible on any exchange.

According to the Bank for International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008)

The BIS survey:

The Bank for International Settlements (BIS) semi-annual OTC derivatives statistics report, for end of June 2008, shows $683.7 trillion total notional amounts outstanding of OTC derivatives with a gross market value of $20 trillion.

See also Prior Period Regular OTC Derivatives Market Statistics).

Of this total notional amount,

Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.

  • Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges.

A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

Derivatives exchanges (by number of transactions) are the:

  • Exchange (which lists KOSPI Index Futures & Options)
  • Eurex (which lists EU products such as interest rate & index products)
  • CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange).

According to Bank for International Settlements, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005.

Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges.

Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges.

Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Clearing and defining what is standard

Addressing a theme that recurs in all the discussions about OTC derivatives regulation, the Treasury framework recommends the amendment of the Commodities Exchange Act (CEA) and the securities laws so that all "standardized" OTC derivatives are required to be cleared through regulated central counterparties (CCPs). Furthermore, the CCPs should be required to impose "robust margin requirements as well as other necessary risk controls."

Treasury has reiterated that "customized" OTC derivatives should not be used to avoid using a CCP, with the creation of a presumption that a contract is standardized if an OTC derivative is accepted for clearing by a CCP.

In addition, Treasury recommends moving "the standardized part of these markets" onto regulated exchanges and regulated transparent electronic trade execution systems for OTC derivatives and requiring a system for the reporting of trade details.

Further, Treasury continues to suggest that regulated financial institutions be encouraged to make greater use of regulated exchange-traded derivatives. These recommendations are presented as a means to contain systemic risk and to improve market efficiency and price transparency.

It is still unclear what parameters would establish whether a product is standardized and, once that is determined, which contracts are to be cleared via CCPs, traded on an electronic trading platform or quoted on a regulated exchange.

Who will determine whether and how to classify a derivative as standardized has not been identified. As we have noted before, since some contracts would be presumed to be standardized because of their acceptance by a CCP, it would appear that there is a voluntary component in the initial decision to submit a trade to a CCP. Which derivatives will be required (versus elected) to be traded in a certain manner is still an open question and no distinctions are being made among various OTC derivatives, some of which may be ill-suited to any of these trading options.

"We would like to highlight that there should be an explicit obligation on access and interoperability for the CCPs on CDS within the supervisory framework of the Recommendations as an essential prerequisite for a vital and undistorted competition between the relevant market infrastructures. Neglecting this prerequisite could cause severe market distortions. Especially smaller and medium-sized market participants would not be able to establish a connection to all upcoming CCPs for the CDS market with the consequence that their brokerage clients will change to clearing members. This could lead to distortions of the CDS market in the sense of oligopolistic structures."

See also CDS clearing

Valuation

Total world derivatives from 1998-2007 compared to total world wealth in the year 2000
Total world derivatives from 1998-2007[1] compared to total world wealth in the year 2000
  • Lacima riskAnalytics Price, quantify risks, manage and optimize financial positions and physical assets within a single application. Analytics provider for risk management.

Valuation explanations link to Wikipedia

Harvard, others suffer massive losses on swaps

"Harvard University’s failed bet that interest rates would rise cost the world’s richest school at least $500 million in payments to escape derivatives that backfired.

Harvard paid $497.6 million to investment banks during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

The transactions began losing value last year as central banks slashed benchmark lending rates, forcing the university to post collateral with lenders, said Daniel Shore, Harvard’s chief financial officer. Some agreements require that the parties post collateral if there are significant changes in interest rates.

“When we went into the fall, we had some serious liquidity management issues we were dealing with and the collateral postings on the swaps was one,” Shore said in an interview today. “In evaluating our liquidity position, we wanted to get some stability and some safety.”

Harvard sold $2.5 billion in bonds in the fiscal year, in part to pay for the swap exit, even as the school’s endowment recorded its biggest loss in 40 years, the annual report said. This is the first time the university has detailed the cost of exiting its swaps.

Further Pressure

“Substantial losses” in Harvard’s General Operating Account, a pool of cash from which bills are paid, further put pressure on the school, the report said. The net asset value of the account fell to $3.7 billion from $6.6 billion during the fiscal year, according to the report.

Harvard has typically invested a large portion of this operating account alongside the endowment, generating “significant positive investment results,” the report said. This year, the endowment’s losses hurt Harvard’s cash, according to the report.

Swaps are a type of derivative where two parties agree to exchange payments tied to a financing, typically receiving a variable-rate for a fixed-rate payment. The terminated contracts include three tied to $431.7 million of bonds the university sold in 2005 and 2007, the annual report said.

Unwinding Swaps

From New York to San Francisco Bay, tax-exempt issuers have paid hundreds of millions of dollars to unwind bond-and-swap transactions officials initially said would cut borrowing costs. The deals fell apart when municipal-bond insurers, who backed much of the underlying debt, lost their AAA ratings in 2008 and interest rates, instead of climbing, plunged to record lows in the worst credit crisis since the Great Depression.

The swaps are often pegged to Securities Industry and Financial Markets Association lending benchmarks or the three- month dollar London-Interbank Offered Rate, known as Libor. Libor closed today at 0.28 percent, from a 10-year high of 6.89 percent on June 1, 2000.

Yale University in New Haven, Connecticut; Georgetown University in Washington and Rockefeller University in New York have reported losses related to interest-rate swaps, in some cases prompting the schools to pay termination fees to end the contracts.

Lawrence Summers

The annual report provides new details on Harvard’s derivative-related losses. Many were entered into in 2004, said Harvard spokeswoman Christine Heenan. Lawrence Summers, director of President Barack Obama’s National Economic Council, was the university’s president at the time. White House spokesman Matthew Vogel declined to comment.

Harvard Management Co., which administers the endowment, has been run since July 2008 by Jane Mendillo, former chief investment officer of nearby Wellesley College. She took over from Mohamed El-Erian, now chief executive officer of Pacific Investment Management Co., which oversees the world’s largest bond fund from Newport Beach, California. He succeeded Jack Meyer, who ran it for 15 years, in February 2006.

Harvard’s loss “says that people don’t understand the complexity of the products they are buying and selling and that doesn’t begin and end with mortgage securities,” said Robert Doty, a municipal finance adviser at American Governmental Services in Sacramento, California.

“It shows that with these products that are so highly complex, people are a long way from knowing as much about these products as they think they do,” he said.

Financing Construction

The Harvard swaps involved bonds sold to finance a medical research building, graduate housing, parking and a Center for Government and International Studies, according to reports from Moody’s Investors Service. They were also used to lock in rates for future bond sales for an expansion of the campus across the Charles River in Boston that has since been scaled back.

Harvard had 19 swap contracts with New York-based Goldman Sachs; JPMorgan Chase & Co.; Morgan Stanley; Charlotte, North Carolina-based Bank of America Corp. and other large banks, according to a bond-ratings report by Standard & Poor’s released on Jan. 18, 2008.

Harvard paid “a large termination fee, but within the range that we’ve heard about over the last year,” Matt Fabian, the senior analyst and managing director of Municipal Market Advisors in Westport, Connecticut, said in an e-mail. “There is a reason why, regardless of the issuer’s sophistication, there should be limits to their exposure to derivatives and variable rate bonds.”

Harvard has frozen employee salaries, slowed hiring, cut staff and offered other workers early retirement as part of a cost-cutting program to compensate for losses in its endowment. The fund, which dropped to $26 billion in value over the fiscal year from $36.9 billion, paid 38 percent of the school’s bills during that time, the report said.

Alumni Request

The Faculty of Arts and Sciences, Harvard’s biggest unit, which includes its undergraduate school, is asking alumni and donors for more funds that can be used immediately and without restrictions to help close a projected $110-million deficit in its 2011 budget, Dean Michael Smith said in a recent speech. Current-use gifts rose 23 percent to $291 million from $237 million in fiscal 2008, the report said.

Harvard might have paid less to escape the swaps if it held out for better terms, Fabian said.

“A lot of issuers don’t have that kind of cash, and so they waited, and relied on their dealers’ patience and largesse to hold off terminating,” Fabian said. “If Harvard had waited, the cost of terminating may well have been lower, but they weren’t willing to take that risk.”


References

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